Risk-Taking, Financial Distress and Innovation

14 Pages Posted: 1 Feb 2011

See all articles by Arnav Sheth

Arnav Sheth

Massachusetts Institute of Technology (MIT); Minerva Schools at KGI

Larry Shepp

Rutgers, The State University of New Jersey - New Brunswick/Piscataway

Oded Palmon

Rutgers Business School

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

Sheth, Arnav and Shepp, Larry and Palmon, Oded, Risk-Taking, Financial Distress and Innovation (January 31, 2011). Available at SSRN: https://ssrn.com/abstract=1752372 or http://dx.doi.org/10.2139/ssrn.1752372

Arnav Sheth (Contact Author)

Massachusetts Institute of Technology (MIT) ( email )

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Minerva Schools at KGI ( email )

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Larry Shepp

Rutgers, The State University of New Jersey - New Brunswick/Piscataway ( email )

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Oded Palmon

Rutgers Business School ( email )

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848-445-3907 (Fax)

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