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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.CORPORATIONS TAKE RISK MANAGEMENT very seriously-recent surveys find that risk management is ranked by financial executives as one of their most important objectives.^ Given its real-world prominence, one might guess that the topic of risk management would command a great deal of attention from researchers in finance, and that practitioners would therefore have a welldeveloped body of wisdom from which to draw in formulating hedging strategies.Such a guess would, however, be at best only partially correct. Finance theory does do a good job of instructing firms on the implementation of hedges. For example, if a refining company decides that it wants to use options to reduce its exposure to oil prices by a certain amount, a BlackScholes type model can help the company calculate the number of contracts needed. Indeed, there is an extensive literature that covers numerous practical aspects of what might be termed "hedging mechanics," from the computation of hedge ratios to the institutional peculiarities of individual contracts.Unfortunately, finance theory has had much less clear cut guidance to offer on the logically prior questions of hedging strategy: What sorts of risks * Froot is from Harvard and NBER, Scharfstein is from MIT and NBER, and Stein is from MIT and NBER. We thank

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. CORPORATIONS TAKE RISK MANAGEMENT very seriously-recent surveys findthat risk management is ranked by financial executives as one of their most important objectives.' Given its real-world prominence, one might guess that the topic of risk management would command a great deal of attention from researchers in finance, and that practitioners would therefore have a welldeveloped body of wisdom from which to draw in formulating hedging strategies. Such a guess would, however, be at best only partially correct. Finance theory does do a good job of instructing firms on the implementation of hedges. For example, if a refining company decides that it wants to use options to reduce its exposure to oil prices by a certain amount, a BlackScholes type model can help the company calculate the number of contracts needed. Indeed, there is an extensive literature that covers numerous practical aspects of what might be termed "hedging mechanics," from the computation of hedge ratios to the institutional peculiarities of individual contracts.Unfortunately, finance theory has had much less clear cut guidance to offer on the logically prior questions of hedging strategy: What sorts of risks * Froot is from Harvard and NBER, Scharfstein is from MIT and NBER, and Stein is from MIT and NBER. We thank

Within an optimal contracting framework, we analyze the optimal number of creditors a company borrows from. We also analyze the optimal allocation of security interests among creditors and intercreditor voting rules that govern renegotiation of debt contracts. The key to our analysis is the idea that these aspects of the debt structure affect the outcome of debt renegotiation following a default. Debt structures that lead to inefficient renegotiation are beneficial in that they deter default, but they are also costly if default is beyond a manager's control. The optimal debt structure balances these effects. We characterize how the optimal debt structure depends on firm characteristics such as its technology, its credit rating, and the market for its assets.

We develop a two-tiered agency model that shows how rent-seeking behavior on the part of division managers can subvert the workings of an internal capital market. By rent-seeking, division mangers can raise their bargaining power and extract greater overall compensation from the CEO. And because the CEO is herself an agent of outside investors, this extra compensation may take the form not of cash wages, but rather of preferential capital budgeting allocations. One interesting feature of our model is that it implies a kind of "socialism" in internal capital allocation, whereby weaker divisions get subsidized by stronger ones.MIT Sloan School of Management and NBER. This paper is a completely overhauled version of our March 1997 NBER working paper (#5969) with the same title. We have received research support from the National Science Foundation and the Finance Research Center at MIT. We are grateful to

JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org.. Oxford University Press is collaborating with JSTOR to digitize, preserve and extend access to The Quarterly This paper analyzes the ways in which financially distressed firms try to avoid bankruptcy through public and private debt restructurings, asset sales, mergers, and capital expenditure reductions. Our main finding is that a firm's debt structure affects the way financially distressed firms restructure. The combination of secured private debt and numerous public debt issues seems to impede out-of-court restructurings and increases the probability of a Chapter 11 filing. In addition, we find that, while asset sales are a way of avoiding Chapter 11, they are limited by industry factors: firms in distressed and highly leveraged industries are less prone to sell assets.VVhen companies are in financial distress, they try to avoid bankruptcy by restructuring their assets and liabilities. Asset sales, mergers, capital expenditure reductions, and layoffs (on the asset side), and restructurings of bank debt and public debt (on the liability side) are all common responses to distress. Absent a quick turnaround in a company's business, a failure to restructure typically results in a Chapter 11 bankruptcy filing.During the past several years there have been a number of studies that analyze these responses to financial distress. Notable contributions include Gilson [1990] on restructurings of bank claims; Gilson, John, and Lang [1990] on debt restructurings versus bankruptcy; Brown, James, and Mooradian [1993] on public debt restructurings versus bank debt restructurings; Brown, James, and Mooradian [1994] on asset sales; and Franks and Torous [1989] and Hotchkiss [1994] on the Chapter 11 process. This paper tries to put these elements together in a more comprehensive study of how firms respond to financial distress. This content downloaded from 91.229.248.162 on Tue, 10 Jun 2014 06:55:05 AM All use subject to JSTOR Terms and Conditions 626 QUARTERLY JOURNAL OF ECONOMICSThis approach also allows us to look at interactions among different kinds of restructurings. Our study is based on a sample of 102 companies that issued high-yield "junk" bonds during the 1970s and 1980s and subsequently got into financial trouble. Of these 102 companies, 76 took visible steps to restructure their companies in response to distress. We have several principal findings. 1. Bank debt restructurings. Banks respond to financial distress in a number of ways. They "loosen" financial constraints on firms by deferring principal and interest, providing new financing, and waiving covenants; they "tighten" financial constraints by accelerating principal and interest payments, reducing lines of credit, and increasin...