The Role of Model Uncertainty in Corporate Risk Management
44 Pages Posted: 29 Jun 2020
Date Written: February 27, 2020
Current corporate risk management theories predict that young firms should hedge more than the established ones. However, the claim is not supported by empirical observations, which also present mixed evidence on whether hedging creates value. This paper attempts to address this puzzle by including model uncertainty as part of risk management process. We develop a dynamic model in which agents learn about a firm’s hedgeability, gauged by the correlation between its operating cash flow and underlying asset of hedging instruments, while weighing the costs and benefits of different risk management tools. The model predicts that resolving model uncertainty accelerates the process of building up hedging positions, but this is not necessarily accompanied with firm value creation. We conclude that dynamic information acquisition is an important determinant of corporate risk management.
Keywords: Corporate Risk Management, Hedge, Cash Holding, Liquidity Risk, Learning
JEL Classification: C61, C63, D21, D83, G01, G13, G32, G33
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