Risk-Taking, Financial Distress and Innovation
14 Pages Posted: 1 Feb 2011
Date Written: January 31, 2011
Abstract
We use our numerical technique to explore the optimality of risk-taking under financial distress. In our model, cash reserves are represented by a Brownian processes that includes an innovation parameter. When this innovation parameter goes to zero, our results show that risk-taking is optimal only when distress costs are extremely high. Thus, non-innovators need a hefty penalty to optimally take risks under financial distress. As the level of innovation increases however, it becomes optimal for innovators to undertake risky investments under financial distress without hefty penalties. The implications of our analysis might partially explain the financial crisis of 2007-2009.
Keywords: Stochastic control, numerical methods, Brownian motion, financial distress, risk management
JEL Classification: C61, D21, D92, G31, G33
Suggested Citation: Suggested Citation
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