Taking Risk Management Theory Seriously
- Topics:
- Commercial Lending
- Tags:
- Finance,
- Financial Planning,
- Financial Services,
- Financing,
- Management,
- Risk Management,
- Security,
- Strategy,
- Theory
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Overview: We study a firm that justifies its novel use of equity derivatives as a cash-flow hedging strategy. Our purpose is to understand the challenge of translating risk management theory into managerial action. Cephalon Inc., a biotech firm, bought a large block of call options on its own stock. If the FDA approved the firm's new drug, the firm would have large cash needs, which the options were designed to meet. We analyze this stated rationale for the firm's choice, applying the cash flow hedging concepts articulated by Froot, Scharfstein and Stein (1993). In applying the theory to practice, there are lessons for both managers and theorists. Managers consider deadweight costs of financing and of risk management, whereas theory tends to ignore the latter costs. While theory is driven by costs of external financing, managers must measure these costs to arrive at decisions and this measurement problem is severe. Cephalon's risk management decisions seem motivated as much by fluctuations in the availability and cost of external financing and by accounting considerations as by fluctuations in operating cash flows or desired investment. Finally, even a field-based examination of this strategy cannot reject the conclusion that the transaction was motivated by goals other than risk management.
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Format: PDF | Size: 356KB | Date: Nov 2003 | Pages: 5
