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CFGT-5: Risk Taking and Risk Management
Short-Term Debt and Incentives for Risk-Taking (Withdrawn)
1APG Asset Management; 2EPFL; 3Federal Reserve Board
We challenge the commonly accepted view that short-term debt curbs moral hazard and show that, in a world with financing frictions, short-term debt does not decrease but instead increases incentives for risk-taking. To demonstrate this result and examine its implications, we formulate a model in which firms face taxation, financing frictions, and default costs. Using this model, we show that short-term debt amplifies shocks, increases default risk, and can give rise to a rollover trap, a scenario in which firms burn cash to cover severe rollover losses. In the rollover trap, shareholders hold an option that is out-of-the-money, which provides them with risk-taking incentives.
Inventory and Corporate Risk Management
1University of Bologna; 2University of Warwick
We examine the role of inventory in corporate risk management with a dynamic model of a firm exposed to costly external finance and featuring endogenous default. We find that inventory management allows net worth risk management irrespective of the level of current net worth, because it does not affect the trade off between external finance and risk management. We show that inventory and cash holdings are synergic tools: while the first is a valuable operational hedge against commodity price risk, the second enhances the hedge offered by inventory in the face of costly external finance. Using our model, we rationalize the empirical incidence of inventory and cash holdings in the cross-section of U.S. manufacturing corporations, showing that savings and storage of raw materials are both positively related to financing constraints and cash flow risk.
Optimal Contracting with Unobservable Managerial Hedging
1Shanghai Jiao Tong University; 2London School of Economics
We develop a continuous-time model where a risk-neutral principal contracts with a CARA agent to initiate a project. The agent can increase the drift of the project's output by exerting costly hidden effort. In addition, the agent can trade the market portfolio and a risk-free bond in an unobservable private account (the managerial hedging behavior). By a meticulous mathematical construction, we are able to solve both the agent's utility maximization problem and the principal's optimal contracting problem through the first-order approach. In the optimal contract, the agent's contract value serves as the unique state variable for the principal to pin-down the optimal contract. The optimal payment to the agent takes the form of an impulse compensation like that in Demarzo and Sannikov (2006). However, the optimal effort and incentive compensation are highly dynamic in our model as in Sannikov (2008). We show that unobservable managerial hedging under absolute performance evaluation is costly for incentive provision in that the principal's value generally decreases with the easiness of managerial hedging. Replacing an absolute performance evaluation contract by a relative one can improve both efficiency and value. Finally, we implement the optimal contract by cash reserve, private debt and private equity in an entrepreneurship context. Dynamic balance sheet, values and market prices of securities are derived and analyzed.
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Conference: EFA 2017
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