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

Authors

  • Diego Amaya,

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    • Diego Amaya is in the Finance Department, Université du Québec à Montréal (UQAM), Québec, Canada. Geneviève Gauthier is in the Department of Management Sciences, HEC Montréal, and GERAD Québec, Canada. Thomas-Olivier Léautier is at the Toulouse School of Economics (IDEI-IAE-CRM), France. Diego Amaya can be contacted via e-mail: amaya.diego@uqam.ca. Diego Amaya would like to thank FQRNT and IFM2 for financial support. Geneviève Gauthier would like to thank NSERC and IFM2 for financial support. An earlier version of this article was circulated under the title, “Coordinating Capital Structure With Risk Management Policies.” We thank seminar participants at the Annual Conference on Risk Management and Corporate Governance, the Annual Australasian Finance and Banking Conference, and the Midwest Financial Association meetings for their comments on earlier versions of this article. Any remaining inadequacies are ours alone.
  • Geneviève Gauthier,

  • Thomas-Olivier Léautier


Abstract

This article 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.

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