Risk Management in Turbulent Times

By Gilles Bénéplanc; Jean-Charles Rochet | Go to book overview

13
The Different Steps of the
Implementation
This chapter recaps the different steps of our methodology and shows how they can be implemented in a consistent fashion. Our methodology essentially follows the usual three steps of risk management described in Chapter 3 (risk mapping, loss control, and risk allocation), but we add a fundamental, indispensable first step: estimating the shareholder value function (SVF).
13.1 ESTIMATING THE SHAREHOLDER VALUE FUNCTION
As we already mentioned, the SVF consists of two things:
A list of fundamental variables that summarize the firm’s accounting and financial situation: earnings, cash reserves, assets in place and investment opportunities, leverage, and cost of capital (or credit ratings).
A function that maps these variables into shareholder value. In other words, the SVF is a way to systematize the assessment that financial analysts perform when they try to predict the way stock markets will react to any new information about the relevant accounting and financial variables identified above.

We have already seen a simple example of SVF, derived from a theoretical model. For simplicity, this SVF is only function of one variable: liquid reserves. In practice, however, other variables matter. The estimation of the SVF is therefore a very delicate exercise, based on past observations, statistical analysis, and probably a good amount of pragmatism.

As an illustration, consider a firm with expected earnings x, productive asset value A and liquid reserves m. Suppose that at each period there is a constant probability λ that the firm is forced to stop its activity (e.g., because of the loss of some key people), in which case the assets are liquidated for a value A. Note that we neglect liquidation costs, but they could easily be introduced. Note also that λ is computed under the risk-neutral probability measure to take risk premia into account. In the absence of financial frictions, the total value of the firm is just equal to the value of liquid reserves m plus the continuation value V0 of its assets, corresponding to the expected present value of future earnings until liquidation plus asset liquidation value. If earnings x and liquidation value A are stationary (a constant growth rate could be introduced without difficulty), this continuation value satisfies:

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