| This dissertation examines how asymmetric information affects two aspects of firms: corporate risk management and the boundary of the firm. First, I examine how firms manage their risks in a setting where external financing is costly and firms have private information on their prospects and risk profiles. In this setting, risk management has two effects on a firm's costs of financing its future investments: risk management affects the variability of the firm's short-term cash flow, which provides internal financing; and it affects the firm's cost of external financing because the realized cash flows alter investors' perception of the firm's prospects. When the firm's internal cash flow is expected to be high, the first effect dominates and risk management helps the firm secure internal financing. By contrast, if the expected internal cash flow is low, the firm may choose a certain degree of exposure. In this case, being exposed to risks reduces the expected dollar cost of external financing even though such exposure increases the firm's probability of having large cash shortfalls. In the second part of the dissertation, the boundary of the firm is analyzed. The integration of two vertically linked business units allows the single owner to choose the compensation contracts of the managers of the two units coordinatively and thus internalizes a production externality when there is technological synergy. On the other hand, vertical integration changes how a disagreement is handled when the two managers cannot agree on a transfer price for the intermediate product. Specifically, integration gives the single owner an extra option: transfer the product without establishing a price. Knowing that the owner cannot commit to costly outside trade, the managers have stronger incentives to disagree on the transfer price and hence the information that would be conveyed by the market prices is lost. The model yields new predictions linking both the integration decision and contract choices to several variables commonly thought to be important for vertical integration. |
