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

44 Pages Posted: 11 Jul 2012 Last revised: 13 Feb 2013

Diego Amaya

Wilfrid Laurier University

Geneviève Gauthier

HEC Montreal - Department of Decision Sciences; HEC Montreal - Department of Management Sciences

Thomas‐Olivier Léautier

University of Toulouse 1 - Toulouse School of Economics (TSE)

Multiple version iconThere are 2 versions of this paper

Date Written: February 10, 2013

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

Suggested Citation

Amaya, Diego and Gauthier, Geneviève and Léautier, Thomas‐Olivier, Dynamic Risk Management: Investment, Capital Structure, and Hedging in the Presence of Financial Frictions (February 10, 2013). Available at SSRN: https://ssrn.com/abstract=2103562 or http://dx.doi.org/10.2139/ssrn.2103562

Diego Amaya

Wilfrid Laurier University ( email )

Waterloo, Ontario N2L 3C5
Canada

Genevieve Gauthier (Contact Author)

HEC Montreal - Department of Decision Sciences ( email )

3000 Côte-Sainte-Catherine Road
Montreal, QC H2S1L4
Canada

HEC Montreal - Department of Management Sciences ( email )

Montreal, Quebec H3T 2A7
Canada

Thomas-Olivier Leautier

University of Toulouse 1 - Toulouse School of Economics (TSE) ( email )

Place Anatole-France
Toulouse Cedex, F-31042
France

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