CHAPTER 3Risk Management and Investment Financing

This chapter explores the technical aspects of the relationship between investment and external financing, in order to help hedging design and optimize risk management policies.

Froot, Sharfstein, and Stein (1993) argue that it may be optimal to protect oneself (or hedge) from fluctuations of different risks if the external sources of investment financing are more costly than the internal sources. This conclusion is pertinent in the presence of high expected default costs, for example concave payoffs or concave profit functions, even if the entrepreneurs are risk-neutral.

Financial hedging with derivatives is not indispensable. In the presence of multiple risks, the correlations between the investment possibilities and the various sources of business risk play an important role in calculating the optimal hedging rate.

As part of integrated or enterprise risk management, it is important to consider all risks simultaneously. For example, the higher the (positive) correlations between cash flows and investment opportunities, the less businesses will need to hedge. Similarly, firms will hedge more if the cash flows and value of the collateral are strongly correlated (or if risk management increases their borrowing opportunities).

Nonlinear risk management instruments provide more precise results in risk hedging than do linear instruments. For example, options are more precise and especially more flexible than futures contracts. ...

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