Dynamic financing and hedging under model uncertainty

ABSTRACT

We extend the classic framework to investigate a firm's optimal financing, investment, payout and hedging strategies under model uncertainty (or ambiguity). It shows that model uncertainty has essentially different effects on liquidity policies compared to traditional business risk. A firm facing model uncertainty prefers refinancing less and payout earlier, and the marginal value may be increased when the refinancing option is in the money. Moreover, our model demonstrates that hedging tools play an important role in mitigating the negative impacts on firm value caused by model uncertainty, which illustrates an interesting result that traditional risk management method works well not only on business risk but also on model uncertainty.

Keywords:

• Model uncertainty
• financing
• ambiguity management
• hedging

JEL CLASSIFICATIONS:

• D81
• E22
• G30

Acknowledgments

Bo Liu acknowledges the support from the National Natural Science Foundation of China [#71573033]. Jinqiang Yang acknowledges the support from the National Natural Science Foundation of China [#71772112, #71972122], Innovative Research Team of Shanghai University of Finance and Economics [#2016110241].

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 We do not distinguish the original and the new shareholders in the model. They are treated equal and therefore we assume they have the same ambiguity aversion parameters, which is similar to Miao and Rivera (Miao and Rivera 2016).

Additional information

Funding

This work was supported by National Natural Science Foundation of China [71573033, 71772112, 71972122] and Innovative Research Team of Shanghai University of Finance and Economics [2016110241].