Dynamic risk management in the presence of convex capital costs: optimal dividend distribution, investment, and hedging policies

Résumé

This paper develops a dynamic model to determine a firm's optimal risk management strategy when it faces uncertainty about its future profitability and investment opportunities, and convex cost of capital. We find that: (1) full hedging is optimal for a wide range of leverage ratios, but that, if the firm is highly indebted, it resorts to gambling for resurrection, and (2) dividend distributions and investment are jointly determine to achieve one of two target leverage ratios -- when feasible. This model sheds light on firms' observed behavior.