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.

Corporate portfolio management

“…Finally, it would be important to introduce the possibility of costly external financing, by allowing the firm to issue new debt or equity when needed. Froot, Scharfstein and Stein [4] do this by assuming a convex cost of external financing. Another possibility would be to endogenize financial frictions by introducing problems of moral hazard or cash flow verifiability, like for example in [1].…”

“…A large academic literature has tried to fill the gap between the theoretical benchmark of perfect capital markets [13] and the practical importance of liquidity and risk management have been explored for explaining why widely held firms appear to exhibit some form of risk aversion: managerial risk aversion [17], tax optimization [16], cost of financial frictions ( [18], [4]). 2 However, none of these articles provide a simple, tractable, measure of how the risk aversion of a corporation varies with its financial situation.…”

“…The case of multiple risky assets, with i.i.d. returns, is a trivial extension 4. We assume that the firm's debt does not bear any default spread.…”

Insurance and ownership structure in India’s corporate sector

“…6 As noted previously in footnote 1, MacMinn and Garven (2000) and Mayers and Smith (1982), among others, argue that insurance is an integral part of corporate financial policy and thus an important strategic issue for board-level managers. Indeed, several prior academic studies (e.g., Froot et al, 1993;Hoyt & Khang, 2000;Mayers & Smith, 1982;Zou & Adams, 2006, 2008aZou et al, 2003) suggest that property insurance can be an effective strategic post-loss investment financing mechanism that can help reduce information asymmetries and financial distress/bankruptcy and other (e.g., agency) costs for firms. In this regard, managers may be motivated to purchase property insurance in order to protect and promote their job security.…”

“…Companies operating in emerging economies are also susceptible to acute unforeseen losses resulting from environmental perils (e.g., fire and flooding), accidents, fraud, and a host of other business risks (Freeman & Kunreuther, 2002;Sarker & Sarker, 2000;Sinha, 2004). 2 Exposure to such risks therefore underpins the need for Indian firms to have sound systems of risk management in order to ensure that operating, finance, and investment plans are not disrupted by a lack of liquidity following unexpectedly acute mishaps to corporate assets (e.g., see Froot, Scharfstein, & Stein, 1993;Zou & Adams, 2006, 2008a.…”