1. Can Risk Management Help Prevent Bankruptcy? Monica Marin Ph.D. Candidate, Finance

2. Motivation Warren Buffett: "Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.“ (2002 Berkshire Hathaway Annual Report)

3. Question and Hypothesis QUESTION:  Are risk management instruments used for risk reduction or for speculation purposes? HYPOTHESIS:  The use of risk management instruments reduces the probability of default.

4. Related Literature Arguments for the use of risk management instruments to:  REDUCE RISK Smith and Stulz,1985 Limited empirical evidence on the relationship between risk management and bankruptcy: · no relationship (Nance, Smith Jr., Smithson(1993), Mian(1996)) · weak relationship (Fok, Carroll, and Chiou, 1997) · strong relationship (Judge, 2006)  SPECULATE Faulkender, 2005: interest rate risk management is driven by speculation

5. Approach I: Duration Model A discrete time duration model (complementary log- log regression)  Takes account of: the sequential nature of the data censoring time-varying covariates

6. Approach II: Distance to Default Structural model (the Black-Scholes-Merton option pricing model)  Advantages: extracts information from market prices computes the probability of default / distance to default independently for any firm  Disadvantages: assumes:  market efficiency  perfect liquidity  lack of arbitrage conditions does not incorporate financial restructuring

7. Approach II: Distance to Default (Contd.) Firm equity ~ a call option on the assets of the firm  strike price equals the value of zero coupon debt with maturity at time T If at time T, then exercise; else let option expire and default The value of the call option is equal to

8. Approach II: Distance to Default (Contd.) The value of the firm: The market value of common equity: Equity volatility & Asset volatility:

9. Approach II: Distance to Default (Contd.) Distance to Default: Expected Default Probability:

10. Data 344 firms: 172 pairs (bankrupt and non-bankrupt) Time period: bankruptcies occurring between 1998 and 2005, followed between 1994 and 2004 Matching criteria: asset size and industry in the fiscal year before bankruptcy

11. GMM Results (Duration Analysis)

12. GMM Results (Distance to Default)

13. GMM Results (Asset Volatility)

14. GMM Results: Changes in DD

15. GMM Results: Changes in AV

16. Conclusion Risk management is associated with:  lower probability of bankruptcy  higher distance to default  lower asset volatility The benefit of using risk management instruments is greater when :  interest rate hedging needs are high  foreign currency hedging needs are high  commodity price hedging needs are low