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 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

Corporate Hedging: The Impact of Financial Derivatives on the Broad Credit Channel of Monetary Policy

“…(1984), Smith and Stulz (1985) and Froot et al (1993)), informational asymmetries create incentives for corporate risk management strategies based on the firm's cash flow. Specifically, we extend the basic framework of Froot et al (1993) to the case of variable interest rates.…”

“…Specifically, we extend the basic framework of Froot et al (1993) to the case of variable interest rates.…”

“…Credit market imperfections based on asymmetric information produce yet another rationale for corporate risk management (Froot et al, 1993). The incentive to hedge is created by variability in a firm's cash flow, for it is cash flow which influences the cost of external finance.…”

“…We follow Froot et al (1993) and restrict the interest rate shock to be symmetrically distributed around zero. This restriction simplifies the analysis considerably and enables the firm to engineer a costless, ie self-financing, hedge.…”

“…Section 3 extends the model to allow for corporate risk management using interest rate derivatives. The model is then analysed following Froot et al (1993). We show that the underlying agency problem creates incentives for corporate hedging and derive the optimal hedging strategy.…”