Question

In their iconic 1958 paper, Miller and Modigliani assume a perfect world and then show that the way a firm finances its assets (debt, equity, or some combination) is irrelevant. To create this perfect world, they make 4 assumptions: 1) capital markets are perfect; 2) all information is symmetric; 3) investment strategy is not affected by a firm’s cash flows; 4) investor and firms can borrow at the same terms.

Which two of these assumptions are important to the theory of risk management? Please explain your answer.

Answer 1

Solution –

The two assumptions which are important for risk management theory are as follows –

1. Capital Markets are perfect – This is an assumption which governs the whole risk management theory. The aspect of capital markets being perfect ensures that there is no arbitrage and all investors have equal rights powers and visibility on the stocks and assets of the company. There are no taxes and stack values adjust to new information. This ensures that risk management is based on principles of the efficient capital markets which corrects itself. All volatility and exposure risks are fully known in such markets and the risk management theory is based on this principle that such uncertainties are covered.
2. Information Symmetry – This is another assumption of risk theory management which states that all information is known and there is no hidden information of knowledge monopolies. This ensures that all decisions are rationale and it is not that one party knows more than the other. The information asymmetry tosses of all risk management principles and hence it is considered that everybody has equal information to apply all risk management theories.