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  • René M. Stulz

    1. Holds the Reese Chair in Banking and Monetary Economics at the Ohio State University, and is also a Bower Fellow at the Harvard Business School and a Research Associate at the National Bureau of Economic Research. Professor Stulz is editor of the Journal of Finance, and is currently at work on a textbook entitled “Derivatives, Risk Management, and Finan-cial Engineering.”*
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  • *

    I am grateful for extensive editorial assistance from Don Chew, and for comments by Steve Figlewski, Andrew Karolyi, Robert Whaley, and participants at a seminar at McKinsey, at the Annual Meeting of the International Association of Financial Engineers, and at the French Finance Association.


This paper presents a theory of corporate risk management that attempts to go beyond the “variance-minimization” model that dominates most academic discussions of the subject. It argues that the primary goal of risk management is not to dampen swings in corporate cash flows or value, but rather to provide protection against the possibility of costly lower-tail outcomes–situations that would cause financial distress or make a company unable to carry out its investment strategy. (In the jargon of finance specialists, risk management can be viewed as the purchase of well-out-of-the-money put options designed to limit downside risk.)

By eliminating downside risk and reducing the expected costs of financial trouble, risk management can also help a company to achieve both its optimal capital structure and its optimal ownership structure. For, besides increasing corporate debt capacity, the reduction of downside risk also encourages larger equity stakes for managers by shielding their investments from “uncontrollables.”

The paper also departs from standard finance theory in suggesting that some companies may have a comparative advantage in bearing certain financial market risks–an advantage that derives from information acquired through their normal business activities. Although such specialized information may lead some companies to take speculative positions in commodities or currencies, it is more likely to encourage “selective” hedging, a practice in which the risk manager's “view” of future price movements influences the percentage of the exposure that is hedged.

But, to the extent that such view-taking becomes an accepted part of a company's risk management program, it is important to evaluate managers' bets on a risk-adjusted basis and relative to the market. If risk managers want to behave like money managers, they should be evaluated like money managers.