Liu, Zhun (2016) Essays on model uncertainty and corporate financial policies. PhD thesis, University of Warwick.

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Abstract

The thesis comprises three essays on model uncertainty and corporate financial policies. Particularly, it studies how model uncertainty affects firm’s choice in financing method in distinct market conditions, as well as the evolution of corporate risk management policy under resolving uncertainty in firm’s profitability and the ability to hedge with derivatives.

Chapter 2 is the first attempt to reconcile prospect theory and contract theory in explaining observed financing decisions. In a world of ambitious and aggressive economic agents, even original equilibria break down in the presence of asymmetric information. When the aggressiveness in the market prevails, multi-pooling-equilibria could exist, which might explain why academics cannot find the optimal leverage. In the meanwhile, debt issuance will be lower, which sheds light on the distinct liquidity provision patterns between bull and bear markets. Firms with lottery-like investment opportunity will get external financing more easily than that with safe projects because both market participants - entrepreneur and financier – will perceive the project to be more valuable than would otherwise be suggested by the classical expected utility theory.

While current corporate risk management theories predict that young firms should hedge more than the established ones, the claim is not supported by empirical observations, which also present mixed evidence on whether hedging creates value. Chapter 3 attempts to address this puzzle by including model uncertainty as part of risk management process. We develop a dynamic model in which agents learn about a firm’s hedgeability, gauged by the correlation between its operating cash flow and underlying asset of hedging instruments, while weighing the costs and benefits of different risk management tools. The model predicts that resolving model uncertainty accelerates the process of building up hedging positions, but this is not necessarily accompanied with firm value creation. We conclude that dynamic information acquisition is an important determinant of corporate risk management.

In Chapter 4, we develop a dynamic model of corporate risk management in which agents learn about a firm’s profitability and balance the costs and benefits of risk management. We depict how the resolution of this particular model uncertainty intertwines with corporate risk management policy. The model predicts that both cash balance and hedging level increase in profitability prospects. We conclude that unraveling profitability drives distinct dynamics in corporate cash management and hedging policy, as a result of trade-off between risk-managing consideration and default option value-maximization. This also yields insights into the puzzles of why young firms use less hedging than mature firms and why there is mixed empirical evidence on the value creation role of corporate risk management.

Item Type:	Thesis (PhD)
Subjects:	H Social Sciences > HG Finance
Library of Congress Subject Headings (LCSH):	Corporations -- Finance -- Mathematical models, Uncertainty, Risk management
Official Date:	September 2016
Dates:	Date Event September 2016 Submitted
Institution:	University of Warwick
Theses Department:	Warwick Business School
Thesis Type:	PhD
Publication Status:	Unpublished
Supervisor(s)/Advisor:	Gamba, Andrea (Professor of finance)
Format of File:	pdf
Extent:	viii, 138 leaves : illustrations, charts
Language:	eng

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