On the interaction among corporate risk management, dividend policy and capital structure

This dissertation explores the rationale for corporate risk management. In the first essay, Corporate Hedging: What, Why and How?, the assumption is made that firms can contractually commit to bondholders to maintain a particular risk management policy, or asset volatility. With that as a starting point, the essay derives the optimal hedge portfolio, examines this portfolio's robustness to variance-covariance misestimation, and proposes a new motive for corporate risk management; a firm that hedges its risk increases its optimal amount of debt and so realizes more tax benefits from leverage. Using the capital structure model of Leland (1994), three impacts of risk-reduction on shareholder value are measured: the increase in tax benefits, the reduction of bankruptcy costs and the reduction in the potential cost of the underinvestment problem. The essay's motivation is to serve as a guide to chief financial officers regarding the benefits of risk management and the sources of those benefits, so that risk management can be undertaken in a way that enhances shareholder value, rather than for its own sake. The second essay, Credible Hedge Commitments, considers a firm in which the risk manager selects a firm's asset volatility for his own benefit and the board of directors selects the amount of leverage, taking the risk manager's behavior into account. An interesting aspect of this paper is that the risk manager is maximizing his utility under the subjective probability measure at the same time as he accounts for his policy's effect on the value of equity, which must be calculated under the risk-neutral probability measure. When a risk manager holds equity, results. First, the stockholder-manager may find his interests more aligned with bondholders than with stockholders; his lack of diversification makes him averse to firm specific risk. Second, this alignment of his interest with bondholders actually benefits stockholders, exante, due to the ability of the firm to lever more highly than it might otherwise. The third essay, Dynamic Risk Management and Dividend Policy under Optimal Capital Structure and Maturity, examines the interaction between a firm's volatility and dividend policies and capital structure and maturity policies. The firm is permitted to costlessly and continuously select any asset volatility and dividend yield, within bounds. Simple and intuitive rules are derived for the firm's optimal dividend and volatility choices. It is found that the firm always optimally selects either the maximal or minimal dividend yield and asset volatility and that these decisions depend, respectively, only on the delta and gamma of the firm's equity. These optimal dividend and volatility policies are then implemented within the context of the Leland and Toft (1996) capital structure model. It is found that firms will optimally select a low dividend yield and a low asset volatility over a greater range of firm asset values the shorter is the maturity of the firm's debt. Anticipating this behavior, bondholders will demand a smaller credit spread for short-term debt when the firm has great leeway in choosing its asset volatility. In turn, this may induce a firm to optimally issue short-term debt. It is also found that the better is a firm's ability to hedge, the more frequently it will refrain from paying dividends. This confirms the well-known result that risk management mitigates incentives for underinvestment. Here it is shown to apply ex-post as well as ex-ante.