Dynamic risk management: investment, capital structure, and hedging in the presence of financial frictions

Abstract

This 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.

JEL codes

Replaced by

Diego Amaya, Geneviève Gauthier, and Thomas-Olivier Léautier, “Dynamic risk management: investment, capital structure, and hedging in the presence of financial frictions”, Journal of Risk and Insurance, vol. 82, n. 2, June 2015, pp. 359–399.

Reference

Diego Amaya, Geneviève Gauthier, and Thomas-Olivier Léautier, “Dynamic risk management: investment, capital structure, and hedging in the presence of financial frictions”, TSE Working Paper, n. 12-330, April 2012.