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

Thomas-Olivier Léautier, Genviève Gauthier, and Diego Amaya,
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Diego Amaya,: Département de finance [Montréal] - UQAM - Université du Québec à Montréal = University of Québec in Montréal

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Abstract: 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

Keywords: INVESTMENTS"; "CAPITAL structure"; "HEDGING (Finance)"; "CAPITAL costs"; "FINANCIAL risk management (search for similar items in EconPapers)
Date: 2015
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Citations: View citations in EconPapers (1)

Published in Journal of Risk and Insurance, 2015, 82 (2), pp.359-399. ⟨10.1111/jori.12025⟩

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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 (2012)
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Persistent link: https://EconPapers.repec.org/RePEc:hal:journl:hal-01316860

DOI: 10.1111/jori.12025

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