Critical Review of Peter Tufano's

Introduction

According to Modigliani and Miller’s irrelevance proposition, corporate financial policy is irrelevant in a perfect financial market. These assumptions include a frictionless market with equal access to market prices, with rational investors and equal access to costless information (Butler, 2008). However it has been recognized that these assumptions of this idealized world are not met in practice. In practice the business environment in which companies operate are characterized by uncertainty. These uncertainties come in unexpected changes of foreign exchange rates, interest rates and commodity prices. Therefor in the real world financial policies are relevant and financial markets not perfect. Cash flows cannot be predicted with certainty and it is for this reason that managers and shareholders require corporate risk management policies as a vital instrument to hedge against these uncertainties. For the minimization of these risk managers have a set of tools at their disposition to help them hedge risk and prevent unwanted losses in their firms’ value. With these comes the problem of the agency conflicts, which is explained by Peter Tufano in his article ‘ Agency Cost of Corporate Risk Management’. Tufano relates the agency conflict concept with cash flow hedging methods, which help companies to avoid costly external financing while adjusting internally generated cash flows to the investment requirements. This paper will review Tufano’s article and highlight the weaknesses of it. Realistic suggestions of how those elements of the article can be improved will be analyzed.

Critical Analysis

Tufano first discusses the advantages that risk management can have when it comes to an uncertain business environment. Two major drivers of risk management actions are shareholder value maximization and managerial risk aversion. Shareholder value maximization is realized when companies engage in risk management actions that lead to an increase of shareholder value. This can be possible through the minimization of costs of financial distress, taxes and the occurrence of the underinvestment problem. A cash flow hedge uses derivative instruments such as call options or put options to limit the individual's exposure to such risks. Managerial risk