Risk Management: Foundations for a Changing Financial World

CHAPTER 30

APPLYING MODERN RISK MANAGEMENT TO EQUITY AND CREDIT ANALYSIS^ad

Robert C. Merton

Traditional conventions of accounting and actuarial science distort the valuation of capital risk in corporations with pension plans because under these conventions, pension assets and liabilities are not included in balance sheet calculations. The modern risk management tools of derivatives technologies can improve both corporate decision making and external analysis of corporations.

Much has been written about the implications that modern enterprise risk management tools have for internal corporate decision making. This article, however, concentrates on the implications of these tools for external analysis. Particularly, I look at the ways that credit and equity analysts can use such tools to evaluate the intrinsic values and risk profiles of the companies they are analyzing. Inadequate analytical tools and overdependence on traditional accounting and actuarial conventions have resulted in systematic distortions in the estimates of company value and economic risk. My purpose, therefore, is to show how modern enterprise risk management tools can be used by external analysts to develop more accurate estimates of value and risk.

I begin by discussing some past distortions in the valuation of pension liabilities, referring particularly to the measurement of pension fund surpluses and deficits before Financial Accounting Standard (FAS) No. 87 (Employers’ Accounting for Pensions, 1985), as ...