Lecture note example

Thanks John. And I think that I post my question in the Ask the Tutor Forum 😀

No, I have not watched free lectures since I do not have much time. Thanks for suggesting though.

I have another question regarding risk management. In an article posted on ACCA website, there is a section of manager behaviour towards risk management.

Could you please explain what does it mean by “concentrated equity stakes” and what does the whole section imply?

The section content is as follows:

“Managers who hold concentrated equity stakes in a corporation face increased levels of risk when compared to other equity holders. As discussed previously, investors hold well-diversified portfolios and face exposure to systematic risk only. But managers with concentrated equity stakes would face both systematic and unsystematic risk. Therefore, they have a greater propensity to reduce the unsystematic risk.

However, if investors do not reward corporations that are reducing unsystematic risk, because they have diversified this risk away themselves. And if a corporation’s managers use the corporation’s resources to reduce unsystematic risk, thereby reducing the corporation’s value. Then it is worth exploring under what circumstances would equity investors allow managers to act to reduce unsystematic risk and whether such actions could actually result in the value of the corporation increasing.

Stulz argues that encouraging managers to hold concentrated equity positions but allowing them to reduce unsystematic risk at the same time, may enable them to act in the best interests of the corporation and the result may be an increase in the corporate value. He explains that managers, who do not have to worry about risks that are not under their control (because they have hedged them away), would be able to focus their time, expertise and experience on the strategies and operations that they can control. This focus may result in the increase in the value of the corporation, although the impact of this increase in value is not easily measurable or directly attributable to risk management activity.

As an aside, one could pose the question, why don’t managers, who are rewarded by equity, diversify the risk of concentrated equity investments themselves? They could sell equity in their own corporation and replace it by buying equity in other corporations. In this way they do not have to hold concentrated equity positions and then would be like the normal equity holders facing only systematic risk. A research study on wealth management, which looked at concentrated equity positions and risk management, found that senior managers are reluctant to reduce their concentrated equity positions because any attempt to sell the equity would send negative signals to the markets, and cause their corporation’s value to decrease unnecessarily.

Contrary to the behaviour of managers who hold concentrated equity stakes, managers who own equity options, which will be converted into equity at a future date, will actively seek to increase the risk of a corporation rather than reduce it. Managers who hold equity options are interested in maximising the future price of the equity. Therefore in order to maximise future profits and the price of the equity, they will be more inclined to undertake risky projects (and less inclined to manage risk). Equity options, as a form of reward, have been often criticised because they do not necessarily make managers behave in the best interests of the corporation or its equity investors, but encourage them to act in an overly risky manner.”

Thanks John. Can you explain more details about this. How reducing unsystematic risk impact shareholder value?