The Role of Model Uncertainty in Corporate Risk Management

44 Pages Posted: 29 Jun 2020

See all articles by Andrea Gamba

Andrea Gamba

University of Warwick - Finance Group

Zhun Liu

University of Central Florida

Date Written: February 27, 2020

Abstract

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

Suggested Citation

Gamba, Andrea and Liu, Zhun, The Role of Model Uncertainty in Corporate Risk Management (February 27, 2020). WBS Finance Group Research Paper, Available at SSRN: https://ssrn.com/abstract=3618742 or http://dx.doi.org/10.2139/ssrn.3618742

Andrea Gamba

University of Warwick - Finance Group ( email )

Scarman Road
Coventry, CV4 7AL
Great Britain
+44 (0)24 765 24 542 (Phone)
+44 (0)24 765 23 779 (Fax)

Zhun Liu (Contact Author)

University of Central Florida ( email )

Orlando, FL 32816-1400
United States

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