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Bailouts, the Incentive to Manage Risk, and Financial Crises

53 Pages Posted: 19 Nov 2006 Last revised: 2 Oct 2008

Stavros Panageas

University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: September 30, 2008

Abstract

A firm's termination leads to bankruptcy costs. This may create an incentive for outside stakeholders or the firm's debtholders to bail out the firm as bankruptcy looms. Because of this implicit guarantee, firm shareholders have an incentive to increase volatility in order to exploit the implicit protection. However, if they increase volatility too much they may induce the guarantee-extending parties to "walk away". I derive the optimal risk management rule in such a framework and show that it allows high volatility choices, while net worth is high. However, risk limits tighten abruptly when the firm's net worth declines below an endogenously determined threshold. Hence, the model reproduces the qualitative features of existing risk management rules, and can account for phenomena such as "flight to quality".

Keywords: Option Pricing, Continuous time stochastic optimization, Implicit Guarantees, Default, Bailouts, Financial Crises

JEL Classification: C0, C6, G0, F3

Suggested Citation

Panageas, Stavros, Bailouts, the Incentive to Manage Risk, and Financial Crises (September 30, 2008). Available at SSRN: https://ssrn.com/abstract=945146 or http://dx.doi.org/10.2139/ssrn.945146

Stavros Panageas (Contact Author)

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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