Foreword to Financial Derivatives Pricing2008 | Derivatives/Options | Book Chapter
Foreword to The World of Equity Derivatives2008 | Derivatives/Options | Book Chapter
MIT Roundtable on Corporate Risk ManagementFall 2008 | Risk Management/Stocks | Paper
Against the backdrop of financial crisis, a distinguished group of academics and practitioners discusses the contribution of financial management and innovation to corporate growth and value, along with the pitfalls and unintended consequences of such innovation. The main focus of most panelists is the importance of a capital structure and risk management approach that complement the strategy and operations of the business. Instructive examples are provided by Judy Lewent, former CFO and head of strategic planning at Merck, and Lakshmi Shyam-Sunder, director of finance and risk management at the International Finance Corporation.
But if these represent successful applications of finance theory, what about the large number of cases where the use of derivatives and other innovations has led to high leverage and apparent risk management failures? Part of the current trouble, as pointed out by Andrew Lo, can be attributed to the failure of risk managers and their models to account for highly improbable events—the so-called fat tails of the distribution. But, as Robert Merton suggests in closing, there is a more comprehensive explanation for today's problems: the tendency of market participants to respond to potentially risk-reducing financial innovation by increasing their risk-taking in other areas. "What we have here," says Merton, are two partly offsetting effects of innovation—one that is reducing the risk of companies and their investors, and another that is encouraging greater risk-taking. From a social or regulatory standpoint, the goal is to find the right balance between these two effects or forces.