Define the term risk management. A firm\'s cash flows are risky for a number of
ID: 2778115 • Letter: D
Question
Define the term risk management. A firm's cash flows are risky for a number of reasons. Identify and discuss five sources of risk or volatility in firm cash flows. Paper should be 2-3 pages not including cover and reference page. Define the term risk management. A firm's cash flows are risky for a number of reasons. Identify and discuss five sources of risk or volatility in firm cash flows. Paper should be 2-3 pages not including cover and reference page. Define the term risk management. A firm's cash flows are risky for a number of reasons. Identify and discuss five sources of risk or volatility in firm cash flows. Paper should be 2-3 pages not including cover and reference page.Explanation / Answer
DEFINITION of 'Risk Management'
The process of identification, analysis and either acceptance or mitigation of uncertainty in investment decision-making. Essentially, risk management occurs anytime an investor or fund manager analyzes and attempts to quantify the potential for losses in an investment and then takes the appropriate action (or inaction) given their investment objectives and risk tolerance. Inadequate risk management can result in severe consequences for companies as well as individuals. For example, the recession that began in 2008 was largely caused by the loose credit risk management of financial firms.
volatility in firm cash flows
The volatility of a firm’s cash flows is widely believed to be an important determinant of the yield spreads for that firm’s bonds. This is consistent with the simple intuition that higher volatility is associated with greater chance of cash shortfalls, resulting in enhanced default probability and so lower expected payoffs for bondholders. Indeed, credit ratings agencies occasionally cite changes in cash flow volatility or, more commonly, earnings volatility as a reason for a change in ratings. For example, on December 13, 2010, Moody’s downgraded Royal Bank of Canada from Aaa to Aa1, noting that the revision was “driven principally by the bank’s commitment to its sizeable and growing capital markets business, which potentially exposes bondholders to increased earnings volatility and poses significant risk management challenges”.1 However, the linkage between cash flow volatility and corporate bond yield spreads has not been extensively examined in the literature. We are not aware of any prior work which has primarily focused on this issue, though several papers which were mostly concerned with the effects of other factors on yield spreads have provided some evidence related to the influence of cash flow uncertainty on spreads. However, several questions have not yet been clearly answered, including: • Compared to other commonly used variables such as interest coverage or leverage ratios, how significant is the effect of cash flow volatility on yield spreads, particularly in an economic sense? • Does the significance of cash flow volatility depend on how it is measured? • Is the effect larger for firms which are at greater risk of default? • Most of the available evidence is cross-sectional in nature, but are there also intertemporal effects for individual firms? The main purpose of this paper is to shed further light on these issues. Based on a large bond trading data set containing investment grade straight bonds and several alternative measures of cash flow risk, we find that cash flow volatility has strong statistical significance as an independent variable in regressions of yield spreads. We also observe that the economic significance of cash flow risk, while not as high as that of variables such as equity return volatility or credit rating, is relatively high in comparison to leverage and measures of debt servicing ability such as the interest coverage ratio and the income to sales ratio. This result is obtained after controlling for several of the spread-informative variables identified in the literature (e.g. Campbell and Taksler, 2003; Chen et al., 2007), and after the inclusion of equity return volatility (Campbell and Taksler, 2003) and other proxies related to cash flow uncertainty such as analyst forecast dispersion and accounting earnings volatility (Guntay and Hackbarth, 2010). Moreover, ¨ when issuing firms are closer to default (as indicated by either a lower credit rating or a lower interest coverage ratio), the economic significance of cash flow volatility is elevated considerably, to the extent that by some measures it surpasses that of equity return volatility. Our cash flow measures include a novel forward-looking measure and several historical measures. The forward-looking measure, which we refer to as “expected cash flow volatility”, is based on regime-switching models (e.g. Hamilton, 1989, 1990; Kim, 1994). This choice is motivated by the fact that cash flow data is reported only on a quarterly basis. Since low frequency data is well-suited to regime-switching models (Hansen, 1992; Calvet and Fisher, 2004), we construct a regime-switching volatility model that allows us to calculate expected cash flow volatility from the projected likelihood of each regime and its associated volatility, using the smoothed probabilities of regimes over time (Kim, 1994). However, since our estimation procedure uses the entire sample, a potential concern with this measure is that it is not investable—i.e. it uses information that is not known as of the observation date for yield spreads. Motivated by this, and also for comparability with the previous literature which has largely used historical measures, we also compute three backward-looking measures of cash flow risk: (i) the standard deviation of the ratio of cash flow to firm market value over the past twelve quarters; (ii) the standard deviation of the ratio of cash flow to the book value of assets over the past twelve quarters; and (iii) the squared value of the change in cash flow for the current quarter relative to the same quarter in the preceding year. The first of these is market-based, the second is book-based, and the third ensures non-overlapping observations while implicitly controlling for seasonality in quarterly data. We use various estimation techniques and specifications to check the robustness of our results. We find that the significance of cash flow risk exists not only cross-sectionally, but also intertemporally using fixed-effects regressions and partial correlation analysis. The cash flow volatility effect is also robust to (i) structural equations which endogenize spread and credit rating; (ii) subperiods distinguishing business cycles, including the current financial crisis; and (iii) measures which can be viewed as proxies for cash flow uncertainty, including analyst forecast dispersion and earnings volatility (Guntay and Hackbarth, 2010), ¨ and idiosyncratic equity return volatility (Campbell and Taksler, 2003). Overall, our study highlights the economic and statistical significance of cash flow risk in valuing corporate bonds.
Related Questions
drjack9650@gmail.com
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.