Benefits of Risk Management

[liewpw05]

Hi David,

I have come across the following question in the reading.

How does tax carrybacks and tax carry forwards affects the tax benefits of risk management?

My understanding is with tax carry forwards, the present value of future taxes can be reduced as current losses can be offset against future taxable profits and hence reduces present value of taxes and reduces the tax benefits of risk management? Not entirely sure if the argument is correct.

Thanks

Regards,
Peggy

 

[David Harper CFA FRM]

Hi Peggy

That's from Stulz, as you know, and (as I read him) he only goes so far as to say that loss carry backs/forwards are a *complicating factor*. He does not say they add/subtract (make better or worse) risk management. So, if you only want to go as far as Stulz, it is a safe statement: they complicate.

That said, I agree with what you write, your argument. My phrasing would be: because carryforwards (carrybacks) give the firm a tool to manage the timing of taxable profits, they decrease (at the margin) the benefits of an risk program that otherwise creates tax benefits. (I don't see the time value of money as central to this argument. I think it can be omitted. Yes, carryforwards/backs are not credited with TVM, but that speaks to a PV calculation; e.g., generally the firm should take the carryback unless they think higher marginal rates loom in the future). Put another way, if CF/CB give the firm a sort of homemade hedge against taxes at the margin, they mitigate the benefit of other hedges.

But only at the margin. The point of Stulz on tax benefits applies to an always-profitable firm: a risk program creates value if it helps "market time" profits to years with higher marginal rates. What affect does CL/CF have on this? At the margin, for some unprofitable firms, they might render other RM-seeking-tax-advantage programs unnecessary. For certain firms (those "lucky" enough to create losses), they provide a *limited* (e.g., limited in duration) but built-in way to tax hedge without derivatives, etc which may be irrelevant but can only be helpful. Therefore, at worst they may render less useful a formal RM aimed at taxes.

David

Edit: I meant to say, "a risk program creates value if it helps "market time" taxable profits to years with lower marginal rates"

 

[sipanivishal]

Hi David,

Besides tax shield and CF anf CB....you have mentioned personal taxes too.......what does that line mean " it is unlikely that taxes create biases in forward contract prices "

Thanks
Sipani

 

[sipanivishal]

Hi David,

I think you forgot to reply to my previous mail.

Thanks
Sipani

 

[David Harper CFA FRM]

Hi Sipani,

In the "tax argument for risk management," Stulz makes a general point (as i wrote above) that risk management could add value by shifting taxable income to periods of lower (marginal) tax rate. But, he says, there are COMPLICATING FACTORS. Including CF/CB and CORPORATE TAX SHIELDS. Then, he lists (#3) as personal (individual) tax but says, "there is no reason to suspect that [personal] taxes create biases.." so it's not it's not a major consideration

David