A Theory of Liquidity and Risk Management Based on the Inalienability of Risky Human Capital∗

We analyze a dynamic optimal financial contracting problem in continuous time with risky cash flows between a risk-averse entrepreneur and risk-neutral investors. Two fundamental constraints on the contracting parties are that: 1) the entrepreneur cannot alienate his human capital, and 2) investors have limited liability protection. Given that human capital is risky, the entrepreneur’s inability to commit his human capital to the firm generates significant distortions for corporate investment and consumption risk-sharing. We show that the optimal contracting problem boils down to a corporate liquidity and risk-management problem (implementable via futures and insurance contracts) for the firm. Our analysis thus provides new foundations for liquidity and risk management policies that firms routinely pursue in practice. ∗We thank Hengjie Ai, Marco Bassetto, Michael Brennan, Wei Cui, Peter DeMarzo, Darrell Duffie, Lars Hansen, Arvind Krishnamurthy, Guy Laroque, Jianjun Miao, Tom Sargent, Suresh Sundaresan, René Stulz, Jeff Zwiebel, and seminar participants at AFR Summer Institute, Caltech, Cheung Kong Graduate School of Business (CKGSB), Columbia Finance Free Lunch, University of Hong Kong, National University of Singapore (NUS), Ohio State University (OSU), Sargent SRG Group, Summer Institute of Finance Conference (2014), Shanghai University of Finance & Economics (SUFE), Stanford Business School, University of British Columbia, University College London, and University of Oxford for helpful comments. First draft: 2012. †Columbia University, NBER and CEPR. Email: [email protected]. Tel. 212-854-9245. ‡Columbia Business School and NBER. Email: [email protected]. Tel. 212-854-3869. §The School of Finance, Shanghai University of Finance and Economics (SUFE). Email: [email protected].