Corporate Risk Management: Integrating Liquidity, Hedging, and Operating Policies

We present a dynamic structural model of integrated risk management that incorporates several motivations for managing risk. Risk management is enabled through a coordination of operating flexibility, liquidity management, and derivatives hedging policies. We analyze the value created by such integrated risk management strategies, and disintegrate this value in several ways to separate out the marginal impacts of specific frictions and of different risk management solutions. We highlight the importance of distress costs as well as a convexity due to personal taxes on equity income. We show that liquidity serves a critical role in risk management, providing a rationalization for seemingly high levels of cash reserves. The value attributable to derivatives usage does not appear to be significant in the presence of other risk management mechanisms, though we identify circumstances where this value is larger, thus helping to resolve conflicting empirical evidence on this issue. We examine why a significant portion of the value loss due to frictions in the presence of uncertainty still remains even under the integrated risk management strategy we employ. Finally, we evaluate the net impact of risk management policies in the presence of financial agency problems that distort these policies. JEL classification: G32