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

Abstract

This paper 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: Dynamic programming, risk management, capital structure, hedging

JEL Classification: G32, C61