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Session Overview
CFGT-5: Risk Taking and Risk Management
Friday, 25/Aug/2017:
1:30pm - 3:00pm

Session Chair: Dirk Hackbarth, Boston University
Location: O133

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Short-Term Debt and Incentives for Risk-Taking

Marco Della Seta1, Erwan Morellec2, Francesca Zucchi3

1APG Asset Management; 2EPFL; 3Federal Reserve Board

Discussant(s): Martin Oehmke (London School of Economics)

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.

EFA2017-273-CFGT-5-Della Seta-Short-Term Debt and Incentives for Risk-Taking.pdf

Inventory and Corporate Risk Management

Marco Bianco1, Andrea Gamba2

1University of Bologna; 2University of Warwick

Discussant(s): Alejandro Rivera (University of Texas at Dallas)

We calibrate a dynamic structural model to examine the role of inventory, together with cash holdings, in corporate risk management. We show that inventory and cash holdings are synergic tools. The first is a valuable operational hedge against commodity price risk, besides offering a costly reserve of liquidity. The second contributes to risk management in states in which storage is ineffective. In the presence of external financing costs, cash holdings support inventory investment enhancing the hedge offered by inventory. With the model, we are able to rationalize the empirical incidence of inventory and cash holdings in the cross-section of U.S. manufacturing corporations, which shows that savings and storage of raw materials are both positively related to financing constraints and cash flow risk.

EFA2017-1621-CFGT-5-Bianco-Inventory and Corporate Risk Management.pdf

Optimal Contracting with Unobservable Managerial Hedging

Yu Huang1, Nengjiu Ju1, Hao Xing2

1Shanghai Jiao Tong University; 2London School of Economics

Discussant(s): Tak-Yuen Wong (Shanghai University of Finance and 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.

EFA2017-1102-CFGT-5-Huang-Optimal Contracting with Unobservable Managerial Hedging.pdf

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