On Thursday, we enter the 3rd and final part of Finance 4335. During the first part of the course, we focused our attention on developing decision rules for risk management by individuals. We base these rules on expected utility theory, which not only captures the effect of risk attitudes on decision-making and the pricing of risk but also produces (as “special” cases) the so-called mean-variance and stochastic dominance models. For a synopsis of the first part of Finance 4335, see “Finance 4335 Midterm 1 Synopsis“.
During the second part of the course, we began by exploring applications of expected utility theory to 1) the demand for insurance and 2) roles played by contract designs in mitigating moral hazard and adverse selection problems that arise from asymmetric information. The combination of these topics along with the Part 1 topics provides the framework needed for modeling risk management decision-making at a personal level. Taken together, the portfolio and capital market theory topics act as a segue for modeling corporate risk management decision-making. The good news is that this approach provides a logically coherent framework for such an effort. The bad news is that portfolio and capital market theory yields a very unsatisfying prediction for corporate risk management. Specifically, since investors have incentives to hold “fully” diversified ownership stakes in firms, apparently firms need not manage so-called “unsystematic” risks (also commonly referred to as idiosyncratic, or unique risks) since investors are already taking care of this problem by being fully diversified. This result is disconcerting because risk management is a critically important “core competency“ for well-managed companies. For a synopsis of the second part of Finance 4335, see “Finance 4335 Midterm Exam 2 synopsis“.
In Part 3 of Finance 4335, we begin by undertaking the study of financial risk management. Specifically, we focus attention on the pricing of financial derivatives, and it is here that we not only develop a logical framework for managing financial risks but also discover why “unsystematic” risks do in fact affect corporate value. So stay tuned!