Can Risk Management Help Prevent Bankruptcy?

Monica MarinPh.D. Candidate, Finance

Motivation

Warren Buffett:

"Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.“

(2002 Berkshire Hathaway Annual Report)

Question and Hypothesis

QUESTION: Are risk management instruments used for risk

reduction or for speculation purposes?

HYPOTHESIS: The use of risk management instruments reduces

the probability of default.

Related Literature

Arguments for the use of risk management instruments to: REDUCE RISK

Smith and Stulz,1985

Limited empirical evidence on the relationship between risk management and bankruptcy:

· no relationship (Nance, Smith Jr., Smithson(1993),Mian(1996))

· weak relationship (Fok, Carroll, and Chiou, 1997)· strong relationship (Judge, 2006)

SPECULATE Faulkender, 2005: interest rate risk management is driven by

speculation

Approach I: Duration Model

A discrete time duration model (complementary log-log regression)

Takes account of: the sequential nature of the data censoring time-varying covariates

Approach II: Distance to Default Structural model (the Black-Scholes-Merton option

pricing model) Advantages:

extracts information from market prices computes the probability of default / distance to default

independently for any firm

Disadvantages: assumes:

market efficiency perfect liquidity lack of arbitrage conditions

does not incorporate financial restructuring

Approach II: Distance to Default (Contd.) Firm equity ~ a call option on the assets of the firm

strike price equals the value of zero coupon debt with maturity at time T

If at time T, then exercise; else let option expire and default

The value of the call option is equal to

DVA

)0,max( , ttA DV

Approach II: Distance to Default (Contd.) The value of the firm:

The market value of common equity:

Equity volatility & Asset volatility:

tAtA

tA dWrdtV

dV

,

,

ATrT

TT

AE VedNeDdNeVV )1()2()1(

T

E

AAE edNV

V )1(

Approach II: Distance to Default (Contd.) Distance to Default:

Expected Default Probability:

T

TDV

DDA

ATA

)2

(ln2

))

2()ln(

(

2

T

TDV

NEDPA

ATA

Data

344 firms: 172 pairs (bankrupt and non-bankrupt)

Time period: bankruptcies occurring between 1998 and 2005, followed between 1994 and 2004

Matching criteria: asset size and industry in the fiscal year before bankruptcy

GMM Results (Duration Analysis)

GMM Results (Distance to Default)

GMM Results (Asset Volatility)

GMM Results: Changes in DD

GMM Results: Changes in AV

Conclusion

Risk management is associated with: lower probability of bankruptcy higher distance to default lower asset volatility

The benefit of using risk management instruments is greater when: interest rate hedging needs are high foreign currency hedging needs are high commodity price hedging needs are low