Dynamic risk management: investment, capital structure, and hedging in the presence of financial frictions
AbstractThis paper develops a dynamic risk management model to determine a firm's optimal risk management strategy. The risk management strategy has two elements: first, until leverage is very high, the firm fully hedges its operating cash how exposure, due to the convexity in its cost of capital. When leverage exceeds a very high threshold, the firm gambles for resurrection and stops hedging. Second, the firm manages its capital structure through dividend distributions and investment. When leverage is very low, the firm fully replaces depreciated assets, fully invests in opportunities if they arise, and distribute dividends to reach its optimal capital structure. As leverage increases, the firm stops paying dividends, while fully investing. After a certain leverage, the firm also reduces investment, until it stop investing completely. The model predictions are consistent with empirical observations.
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Bibliographic InfoPaper provided by Institut d'Économie Industrielle (IDEI), Toulouse in its series IDEI Working Papers with number 737.
Date of creation: Apr 2012
Date of revision:
Publication status: Published in Journal of Risk and Insurance, 2013.
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Other versions of this item:
- Amaya, Diego & Gauthier, Geneviève & Léautier, Thomas-Olivier, 2012. "Dynamic risk management: investment, capital structure, and hedging in the presence of financial frictions," TSE Working Papers 12-330, Toulouse School of Economics (TSE).
- C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
- G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
This paper has been announced in the following NEP Reports:
- NEP-ALL-2012-09-30 (All new papers)
- NEP-BEC-2012-09-30 (Business Economics)
- NEP-DGE-2012-09-30 (Dynamic General Equilibrium)
- NEP-RMG-2012-09-30 (Risk Management)
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