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Dynamic Risk Management: Investment, Capital Structure, and Hedging in the Presence of Financial Frictions

Author

Listed:
  • Diego Amaya
  • Geneviève Gauthier
  • Thomas-Olivier Léautier

Abstract

type="main" xml:lang="en"> This article develops a dynamic risk management model to determine a firm's optimal risk management strategy. This strategy has two elements. First, for low-leverage values, the firm fully hedges its operating cash flow exposure, due to the convexity of 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 low, the firm replaces depreciated assets, fully invests in opportunities if they arise, and distribute dividends, all of these together to achieve 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 stops investing completely. The model predictions are consistent with empirical observations.

Suggested Citation

  • Diego Amaya & Geneviève Gauthier & Thomas-Olivier Léautier, 2015. "Dynamic Risk Management: Investment, Capital Structure, and Hedging in the Presence of Financial Frictions," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 82(2), pages 359-399, June.
    • Handle: RePEc:bla:jrinsu:v:82:y:2015:i:2:p:359-399
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    Cited by:

    1. Jiaqi Jiang & Yun Feng, 2023. "Optimal hedging in the presence of internal flexibility," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 28(4), pages 4557-4571, October.
    2. Benjamin L. Collier & Andrew F. Haughwout & Howard C. Kunreuther & Erwann O. Michel‐Kerjan, 2020. "Firms’ Management of Infrequent Shocks," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 52(6), pages 1329-1359, September.

    More about this item

    JEL classification:

    • 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

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