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A model for the optimal risk management of (farm) firms

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  • Svend Rasmussen

    ()
    (Department of Food and Resource Economics, University of Copenhagen)

Abstract

Current methods of risk management focus on efficiency and do not provide operational answers to the basic question of how to optimise and balance the two objectives, maximisation of expected income and minimisation of risk. This paper uses the Capital Asset Pricing Model (CAPM) to derive an operational criterion for the optimal risk management of firms. The criterion assumes that the objective of the firm manager is to maximise the market value of the firm and is based on the condition that the application of risk management tools has a symmetric effect on the variability of income around the mean. The criterion is based on the expected consequences of risk management on relative changes in the variance of return on equity and expected income. The paper demonstrates how the criterion may be used to evaluate and compare the effect of different risk management tools, and it illustrates how the criterion should be applied to integrate risk management at the strategic, tactical and operational level. The paper concludes that the derived criterion for optimal risk management provides a valuable theoretical tool for the economic evaluation of the consequences of risk management.

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File URL: http://okonomi.foi.dk/workingpapers/WPpdf/WP2013/IFRO_WP_2013_10.pdf
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Bibliographic Info

Paper provided by University of Copenhagen, Department of Food and Resource Economics in its series IFRO Working Paper with number 2013/10.

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Length: 25 pages
Date of creation: May 2013
Date of revision:
Handle: RePEc:foi:wpaper:2013_10

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Web page: http://www.ifro.ku.dk/
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Related research

Keywords: firm value; CAPM; optimal risk management; return on equity; risk; expected income;

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  1. Harry Markowitz, 1952. "Portfolio Selection," Journal of Finance, American Finance Association, vol. 7(1), pages 77-91, 03.
  2. Hanoch, G & Levy, Haim, 1969. "The Efficiency Analysis of Choices Involving Risk," Review of Economic Studies, Wiley Blackwell, vol. 36(107), pages 335-46, July.
  3. Nartea, Gilbert V. & Webster, Paul, 2008. "Should farmers invest in financial assets as a risk management strategy? Some evidence from New Zealand," Australian Journal of Agricultural and Resource Economics, Australian Agricultural and Resource Economics Society, vol. 52(2), June.
  4. William F. Sharpe, 1964. "Capital Asset Prices: A Theory Of Market Equilibrium Under Conditions Of Risk," Journal of Finance, American Finance Association, vol. 19(3), pages 425-442, 09.
  5. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
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