Collateral, Risk Management, and the Distribution of Debt Capacity

Abstract

Collateral constraints imply that financing and risk management are fundamentally linked. The opportunity cost of engaging in risk management and conserving debt capacity to hedge future financing needs is forgone current investment, and is higher for more productive and less well-capitalized firms. More constrained firms engage in less risk management and may exhaust their debt capacity and abstain from risk management, consistent with empirical evidence and in contrast to received theory. When cash flows are low, such firms may be unable to seize investment opportunities and be forced to downsize. Consequently, capital may be less productively deployed in downturns.Financing and risk management are fundamentally linked as both involve promises to pay that are limited by collateral constraints. Engaging in risk management and conserving debt capacity have an opportunity cost -current investment is forgone. This cost is higher for more constrained firms. This insight has important implications for the extent of corporate risk management.

The Collateral Channel: How Real Estate Shocks Affect Corporate Investment

“…3 For other contributions emphasizing the role of collateral in boosting pledgeable income, see, among others, Eisfeldt and Rampini (2009) and Rampini and Viswanathan (2010).…”

Risk Management with Supply Contracts

“…First, firms may refrain from using traded derivatives when collateral constraints bind near distress (Rampini and Viswanathan, 2010). The evidence from the introduction of steel futures supports the importance of collateral constraints.…”

“…The first friction firms may face is a collateral constraint as in Rampini and Viswanathan (2010). The collateral constraint creates a motivation for hedging, as a negative shock to cash 6 flow may cause inefficient liquidation of the firm's investment.…”

Financial Crises and Lending of Last Resort in Open Economies

“…Appendix B reports the details of the computation. Aiyagari and Gertler (1999), Mendoza and Smith (2006) and Rampini and Viswanathan (2010) for a discussion of the asset pricing and risk management implications of models with collateral constraints. s 1 are the consumption and the nominal exchange rate in logs at date 1, andw 1 is the nonfinancial present value of households' income at date 1, also in logs.…”