Risk Management: Foundations for a Changing Financial World

CHAPTER 7

VALUE AND RISK: BEYOND BETAS^g

Aswath Damodaran

Risk is narrowly defined in most financial analyses as systematic or nondiversifiable risk, and its effects on value are isolated to the discount rate. Generally, the costs of equity and capital are set higher for riskier companies and the resulting value is considered to be risk adjusted. In conjunction, risk management is considered to be primarily defensive—that is, firms protecting themselves against risks by using risk-hedging products, such as derivatives and insurance. I argue here for both a more expansive analysis of risk in valuation and a much broader definition of risk management. I believe that effective risk management can sometimes include aggressively seeking out and exploiting risk and that it can alter investment policy and affect expected cash flows.

RISK MANAGEMENT VS. RISK REDUCTION

The Chinese symbol for risk is a combination of two symbols—one for danger and one for opportunity. Although risk can have very negative consequences for those who are exposed to it, risk is also the reason for higher returns to those who use it to their advantage. Risk management as defined in practice misses this important duality and focuses on the negative consequences of risk. In fact, when risk management is discussed in corporate offices, consulting firms, and investments banks, what is being talked about is risk reduction, usually through the use of derivatives and insurance.

Risk reduction is a part of risk management, ...