Why Manage Risk? Harvard Case Solution & Analysis


            Risk Management in the corporate world is considered as vitally important by all the companies around the world. There are many types of risks faced by a corporation but in order to mitigate the impact of the financial risk faced by the corporations and minimize the variability of, the returns of the company firms need to adopt risk management techniques today. Nowadays, the view is different where risk management and hedging strategies are considered as a tool for shareholder wealth maximization and corporate risk minimization.

However, the traditional view was that risk management is an unnecessary cost which only results in the outflow of the funds from the company. Nonetheless, the clear evidence for the growth in the financial markets around and for the importance of the risk management products is that today the financial products markets constitutes as one of the major financial market around the world. The most recent notional amount of the financial markets totaled around $ 55.7 trillion.

There are many people around the world such as the academic writers of America who argue that when the shareholders of the company are diversified, then in the absence of the market imperfections their wealth is negatively impacted. However, the detailed financial literature provides us with thousands of examples and situations where corporate risk management has resulted in increased shareholder value(Allayannis, 2001). This paper attempts to define the advantages and limitations of financial derivatives in today’s financial markets and also explains the various types of derivative instruments offered in the market today.

Advantages and Limitations of Financial Derivatives

Advantages of Financial Derivatives

            There are many advantages associated with derivatives which could be seen in the today’s sophisticated international markets. In today’s world most of the businesses are going international as a result of globalization. The use of derivative instruments in these companies can help them to mitigate their translation exposure and provide them with global diversification in their currencies by helping them again deflation, inflation and fluctuating interest rates.

            Two of the most popular and significantly recognized benefits of using financial derivatives are the risk management and price discovery. For instance, if we talk about price discovery benefit then companies can make use of future contracts (discussed below) to disperse the assets of the company geographically irrespective of having many prices in existence(Allayannis G. U., 2004). The second benefit is of risk management and by using financial derivatives; the companies can easily identify their optimal hedge ratio and hedge their positions accordingly.

Financial derivatives also improve the market efficiency of the underlying assets of the company. The costs of these financial instruments are usually low as compared to the benefits that would flow to the company therefore; people can transact huge transactions with small amounts. Overall, financial derivatives have become one of the important tool in today’s world where all the financial centers, banks, exchanges and businesses are connected(Bartram, 2002). Lastly, they are one of the innovative products and there is no scenario or transaction which cannot be hedged with financial derivatives.

Limitations of Financial Derivatives

            Along with significant advantages of derivatives there are also many disadvantages and limitations associated with financial derivatives. If they are not managed properly they can result in huge losses for the companies. Also, it is very difficult to handle financial derivatives as they are highly complex and if they are not handled properly then the consequences for the company would be terrible. Along with these issues, the main disadvantage of financial derivatives is that it provides the room too many people to create speculative positions in the derivatives market. Most of the people consider the derivatives market as a gambling market where people come to play and invest to make big money. Secondly, the derivatives themselves might be undervalued because they too are dependent upon a number of assumptions which keep on changing with the state of the market.

Irrelevancy Theory by Modigliani and Miller

            The capital structure of the company is the distribution of the debt and the equity in order to finance the assets of the company. Modigliani and Miller had derived the capital structure irrelevancy theory in the year 1950 which is today called as the capital structure irrelevancy theory. The main proposition under this theory states that the capital structure of any company does not affects the enterprise value of that company............

This is just a sample partial case solution. Please place the order on the website to order your own originally done case solution.

Share This