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Risk Management: Coordinating Corporate Investment and Financing Policies

Authors

  • KENNETH A. FROOT,

  • DAVID S. SCHARFSTEIN,

  • JEREMY C. STEIN

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    • Froot is from Harvard and NBER, Scharfstein is from MIT and NBER, and Stein is from MIT and NBER. We thank Don Lessard, Tim Luehrman, André Perold, Raghuram Rajan, Julio Rotemberg, and Stew Myers for helpful discussions. We are also grateful to the IFSRC and the Center for Energy Policy Research at MIT, the Department of Research at Harvard Business School, the National Science Foundation, and Batterymarch Financial Management for generous financial support.

ABSTRACT

This paper develops a general framework for analyzing corporate risk management policies. We begin by observing that if external sources of finance are more costly to corporations than internally generated funds, there will typically be a benefit to hedging: hedging adds value to the extent that it helps ensure that a corporation has sufficient internal funds available to take advantage of attractive investment opportunities. We then argue that this simple observation has wide ranging implications for the design of risk management strategies. We delineate how these strategies should depend on such factors as shocks to investment and financing opportunities. We also discuss exchange rate hedging strategies for multinationals, as well as strategies involving “nonlinear” instruments like options.

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