Clara Raposo

Abstract

This paper links real investment policy to corporate risk management, endogenizing the costs of external financing. Previous literature finds investment efficiency linked to full hedging. In this model, a firm with proprietary information when deciding its investment in a valuable project, may not choose to fully hedge in equilibrium, and this can improve investment efficiency. The size of the project, the hedged value of cash-earnings, and the timing of information revelation, influence the risk management equilibrium. Results are derived under a constraint of no-distress at the time of the investment decision. When this constraint is relaxed, it results in a bargaining situation between shareholders, the counterparty on the contract utilized to manage risk, and new investors. Depending on the bargaining solution, the firm may still prefer to "not hedge", facing distress in some states. When this occurs investment efficiency is enhanced. The sources of external finance are debt and equity. The issue of disclosure regarding risk exposure plays a crucial role.

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