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

Diego Amaya, Geneviève Gauthier and Thomas-Olivier Léautier

No 12-330, TSE Working Papers from Toulouse School of Economics (TSE)

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: C61 G32 (search for similar items in EconPapers)
Date: 2012-04
New Economics Papers: this item is included in nep-bec, nep-dge and nep-rmg
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Related works:
Journal Article: Dynamic Risk Management: Investment, Capital Structure, and Hedging in the Presence of Financial Frictions (2015)
Working Paper: Dynamic risk management: investment, capital structure, and hedging in the presence of financial frictions (2015)
Working Paper: Dynamic risk management: investment, capital structure, and hedging in the presence of financial frictions (2012)
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Persistent link: https://EconPapers.repec.org/RePEc:tse:wpaper:26110

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