Disintegrating Risk Management

We present a dynamic structural model of integrated risk management. Several motivations for managing risk are incorporated into the model, including costs associated with external financing, distress and bankruptcy, and convexities in both corporate and personal tax structures. Risk management is enabled through a coordination of operating flexibility, liquidity management, and hedging with derivatives. We analyze the value created by this integrated risk management structure, disintegrate this value in several ways, and examine why it falls short of the value associated with a perfect risk management contract that would return firm value to that in a frictionless world. We study the relative contribution of the various rationales for managing risk, and highlight the importance of distress costs, as well as a convexity due to personal taxes on equity income that has not been emphasized to date in the literature. We also isolate the marginal contributions of the different mechanisms to manage risk. We show that liquidity serves a critical role in risk management, despite the tax penalty associated with holding cash, which provides a rationalization for the high levels of cash observed in recent empirical studies. 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 might be larger, thus helping to resolve conflicting empirical evidence on this issue. We also evaluate the impact of financial agency problems that may result in speculative derivatives positions, and examine the efficacy of imposing position limits in corporate risk management policies.