Corporate Risk Management

CHAPTER 2Theoretical Determinants of Risk Management in Non-Financial Firms

This chapter presents and analyzes the factors that motivate non-financial firms to hedge their risks based on arguments brought forth by Stulz (1996) in an important article on risk management. Stulz has also published a book on risk management (Stulz, 2003). He is one of the main contributors to the literature that explains why some non-financial firms choose to invest in risk management while others do not. Stulz expands on his 1996 paper with an article published in 2013 in which he analyzes examples of firm behavior with respect to risk management during the recent financial crisis.

Stulz's 1996 article sheds light on the differences between what the first risk management theorists proposed and what is observed in practice. In general, certain financial theorists suggested that firms should almost always use derivatives to hedge their currency risk, interest rate risk, and risk related to commodity prices, whereas others recommended routine use of market insurance to hedge against other risks such as pure risks.

Stulz (1996) argues that when making decisions pertaining to risk management, firms need to take a value-maximizing approach as opposed to focusing solely on the hedging efficiency of different tools.

As we will see, large non-financial firms use less market insurance than the amount recommended by traditional models and, oddly enough, tend to favor the use of derivatives more than smaller ...