Corporate full-scale hedging and pricing of high-risk growth investment option

Ons Triki () and Fathi Abid ()
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Ons Triki: University of Sfax, Faculty of Economic and Management Sciences
Fathi Abid: University of Sfax, Faculty of Economic and Management Sciences

Review of Derivatives Research, 2025, vol. 28, issue 3, No 2, 42 pages

Abstract: Abstract This paper addresses the problem of companies developing innovative investment projects for which they only have partial information. The idea is to propose a comprehensive approach that ensures optimal hedging of the inherent risks of real investment options through the market by creating a diversified portfolio and by issuing CoCo bonds, acting on the financial structure according to the level of the company's systematic and specific risks. The valuation of stocks, subordinated bonds (SBs), and contingent convertible bonds (CoCos) involving idiosyncratic risk is examined in this paper for a business that has invested in a project that generates perpetual cash flows with an unobservable drift parameter. We assume that the investor decides to partially hedge the estimation risk and the cash flow risk by investing in financial market. Using intertemporal utility and stochastic dynamic optimisation approaches, we evaluate the optimal capital structure and calculate the implicit value of the company's assets. The results reveal that, in the presence of convertible debt, the dynamics between market returns and the company's investment cash flows are traded off, providing strategic flexibility and reducing upfront financing costs. CoCo debt seems to be advantageous for companies with a high correlation between the market return and investment cash flow in a turbulent period. However, companies with a low correlation can use it to finance their expansion. This study provides a theoretical contribution to the field of quantitative corporate finance and risk management regarding the financing of CoCos bonds and investment decision-making for risk-averse investors in an incomplete market, where the project return is assessed in an uncertain environment.

Keywords: Contingent convertible debt; Real investment option; Idiosyncratic risk; Partial information; Risk aversion; Diversified portfolio (search for similar items in EconPapers)
JEL-codes: D81 G12 G32 (search for similar items in EconPapers)
Date: 2025
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DOI: 10.1007/s11147-025-09218-3

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