59 Pages Posted: 16 Mar 2010 Last revised: 29 Mar 2012
Date Written: February 16, 2012
Firms face uncertain financing conditions, which can be quite severe as exemplified by the recent financial crisis. We capture the firm's precautionary cash hoarding and market timing motives in a tractable model of dynamic corporate financial management when external financing conditions are stochastic. Firms value financial slack and build cash reserves to mitigate financial constraints. The finitely-lived favorable financing condition induces them to rationally time the equity market. This market timing motive can cause investment to be decreasing (and the marginal value of cash to be increasing) in financial slack, and can lead a financially constrained firm to gamble. Quantitatively, we find that firms' optimal responses to the threat of a financial crisis can significantly smooth out the impact of financing shocks on investments, marginal values of cash, and the risk premium over time. Thus, a firm may still appear unconstrained based on its relatively smooth investment over time despite significant underinvestment. This smoothing effect can be used to disentangle financing shocks from productivity shocks empirically.
Keywords: risk management, liquidity, financial crisis, market timing, investment, q theory
JEL Classification: E22, E44, G3
Suggested Citation: Suggested Citation
Bolton, Patrick and Chen, Hui and Wang, Neng, Market Timing, Investment, and Risk Management (February 16, 2012). AFA 2012 Chicago Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1571149 or http://dx.doi.org/10.2139/ssrn.1571149
By Meb Faber