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Risk Management: Coordinating Corporate Investment and Financing Policies

Risk Management: Coordinating Corporate Investment and Financing Policies,Kenneth A Froot,David S Scharfstein,Jeremy C Stein

Risk Management: Coordinating Corporate Investment and Financing Policies   (Citations: 692)
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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. Copyright 1993 by American Finance Association.
Published in 1993.
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    • ...Unlike the model of Froot, Scharfstein, and Stein (1993) (FSS hereafter), our model does not focus on how the investment policy is financed but rather on the simultaneous decision-making of the hedging and leverage policies for a given investment decision...

    Georges Dionneet al. On risk management determinants: what really matters?

    • ...From this analysis and considering the specific determinants of FX hedging in AIM firms, we evaluate the following possible explanations for FX hedging: (i) the reduction in costs of financial distress (Smith and Stulz 1985), (ii) the reduction of the risk of underinvestment (Froot, Scharfstein, and Stein 1993), (iii) the reduction of tax (Smith and Stulz 1985), (iv) the managerial incentives to reduce risk exposure (Smith and Stulz 1985), and (v) other determinants of hedging based on the financial characteristics of AIM firms such as size, internationalisation, liquidity, corporate governance and the industry sector...

    Andrew Marshallet al. The determinants of foreign exchange hedging in Alternative Investment...

    • ...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 ;Z ou &A dams,2006, 2008a)...
    • ...Indeed, several prior academic studies (e.g., Froot et al., 1993; Hoyt & Khang, 2000; Mayers & Smith, 1982 ;Z ou & Adams, 2006, 2008a ;Z ou 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...
    • ...Weston (2001), we measure firms’ growth options as the lagged value of annual capital expenditure / annual sales, and predict that firms with more growth options are likely to insure (and insure more) than other firms as hedging minimizes underinvestment when cash flows are low, which is likely to be the case after a severe loss event (e.g., see also Froot et al., 1993)...
    • ...This finding suggests that the market value of younger Indian firms could comprise mainly growth opportunities rather than assets-in-place, and that managers in these entities are motivated to increase their insurance coverage in order to protect future cash flows and investment plans from unexpected severe loss events (e.g., see Froot et al., 1993)...

    Joy Jiaet al. Insurance and ownership structure in India’s corporate sector

    • ...These include reductions in the expected costs of financial distress (Smith and Stulz, 1985), decreased tax liabilities in the presence of a convex tax schedule (Graham and Rogers, 2002), smoother earnings (Barton, 2001), lower levels of information asymmetry (DeMarzo and Duffie, 1995; DaDalt et al, 2002), lower cost of debt (Leland, 1998) and the alleviation of underinvestment problems (Froot et al, 1993; Gay and Nam, 1998)...

    Peter J. DaDaltet al. Do derivatives affect the use of external financing?

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