Are Managers Measuring the Financial Risk in the Right Manner? An Exploratory Study

Abstract

The basic problem with corporate finance is that it deals with the fundamental analysis issues while the tools used are those applicable for technical analysis. That is the reason why finance managers often arrive at wrong decisions which snowball into issues like the subprime crisis. Initially, Markowitz model was used to calculate risk for portfolio management. It gave importance only to systematic risk as unsystematic risk could be avoided through diversification. Later on, CAPM model was developed for corporate finance and project finance for calculation of risk. Finance models dealing with risk management are applicable only for a short period and that too for an average of a large number of companies. The approach to apply risk measurement technique suitable for portfolio management to corporate finance is not correct. Even the econometric techniques applied to validate calculation of risk for portfolio management should be different from those applied for corporate finance. The present article analyses the problems of applying such risk measurement techniques for corporate finance purpose. A company faces mainly two types of risks: liquidity risk and bankruptcy risk. In case a company suffers from bankruptcy threat (which may or may not lead to actual bankruptcy), i.e., possibilities of closure due to losses, there will be two possibilities: The company may move with market index in normal times while it may come down suddenly with index and may not bounce back (Kink in the beta curve), as in the case of MTNL and Jet Airlines. There may be a sudden bankruptcy threat as in the case of Satyam. The latter case does not allow investors to react. However, corporate managers will have to take account of the first possibility of bankruptcy risk which cannot be ignored by assuming beta to be constant. This paper examines three companies, Mastek, Jet Airlines, and MTNL, in this category. The author suggests that instead of segregating risk into systematic and unsystematic risk, it should be segregated into bankruptcy and liquidity risk. In this way, unsystematic risk is also priced while determining the value of a company.