CONIC FINANCE AND THE CORPORATE BALANCE SHEET

Dilip B. Madan () and Wim Schoutens ()
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Dilip B. Madan: Robert H. Smith School of Business, Van Munching Hall, College Park, MD 20742, USA
Wim Schoutens: Department of Mathematics, K. U. Leuven, Celestijnenlaan 200 B, B-3001 Leuven, Belgium

International Journal of Theoretical and Applied Finance (IJTAF), 2011, vol. 14, issue 05, 587-610

Abstract: Markets are modeled as passively accepting a convex cone of cash flows that contain the nonnegative cash flows. Different markets are modeled using different cones that reflect the clientele of the market. Conditions are established to exclude the possibility of arbitrage between markets. Operationally these cones are defined by a positive expectation under a concave distortion of the distribution function of the cash flow delivered to market. Under conic finance firms may access risky assets and risky liabilities but regulatory bodies need to ensure that sufficient capital is put at stake to make the risk of excess loss acceptable to taxpayers. Firms approach equity markets for funding and can come into existence only if they can raise equity capital sufficient to meet regulatory requirements. Firms that are allowed to exist may approach debt markets for favorable funding opportunities. The costs of debt limit the amount of debt. Firms with lognormally distributed and correlated assets and liabilities are analysed for their required capital, their optimal debt levels, the value of the option to put losses back to the taxpayer, the costs of debt and equity, and the level of finally reported equity in the balance sheet. The relationship between these entities and the risk characteristics of a firm are analyzed and reported in detail.

Keywords: Concave distortions; clientele effects; capital requirements; taxpayer put option; liability valuation; two price markets; bid and ask prices (search for similar items in EconPapers)
Date: 2011
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DOI: 10.1142/S0219024911006541

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