Risk Management, Risk Capital, and the Cost of Capital

In a recent JACF article, Prakash Shimpi proposed a new way of calculating a firm's cost of capital that incorporated a concept of “risk capital” as well as operational capital. The premise of the Shimpi approach was that purchasing hedging instruments effectively “releases” equity that is no longer needed to ensure the firm's creditworthiness. This article shows that Shimpi's cost of capital calculations incorporate this released equity in a misleading way, exaggerating the capital base and underestimating its true cost. It also demonstrates how conventional cost of capital approaches can be modified to integrate risk capital, thereby avoiding such distortions and accurately representing the cost of capital of a company with a policy of active risk management.