Risk Management: Coordinating Corporate Investment and Financing Policies

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. 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

A Review of Corporate Hedging Models and Their Relevance in Corporate Finance

“…Another important contribution by [27] is the reduction of variability in the internal funds through hedging and thus reducing dependency on costlier external finance.…”

“…This paper also states the rationale for hedging-"without hedging, firms may be forced to under invest in some settings because it is costly to raise external finance ( [27]: p. 1633). This study details about the risk management and financial structure in a sequential contracting context/settings.…”

“…In [27], under fixed investment model, corporate hedging supersedes gambling as an entrepreneur is indifferent between these two. On the similar lines, [56] stated that, "when agency cost is linear in investment, hedging is optimal for concave production function (risk averse) while gambling is optimal if indivisibility of investment is present, which does not allow investors to get threshold cash on hand".…”

“…A study by [27] investigated the link between investment and risk management under costly external finance. This paper also states the rationale for hedging-"without hedging, firms may be forced to under invest in some settings because it is costly to raise external finance ( [27]: p. 1633).…”

“…Further, this setting describes the need for full hedging or partial hedging or not hedging as special cases. Here hedging strategy depends upon the coefficient of relationship internal funds and investment (financing) opportunity [27].…”