"Market Timing, Investment, and Risk Management"
Working paper,
February
2011
Publication type: Working paper
Research Archive Topic: Business Economics and Public Policy, Corporate Finance
Abstract
How should firms optimally time equity market opportunities? And how should they adapt their investment, payout and dynamic hedging decisions to changing market financing opportunities? We show that only firms with low cash-to-asset ratios should carry out new equity issues to take advantage of favorable equity market opportunities. Firms with high cash-to-asset ratios optimally respond to fleeting market opportunities by both delaying payouts to shareholders and by cutting back investment. We model market financing opportunities risk through switching probabilities between two states of nature with respectively low and high external costs of equity financing. The most striking result of our analysis is that market timing introduces convexity in the firm's value function, which gives rise to a non-monotonic investment policy in the firm's cash-to-asset ratio: investment at first declines with the cash-to-asset ratio, then rises and then again declines. This convexity also gives rise to a complex dynamic hedging policy, with the firm increasing its exposure to aggregate risk when its cash-to-asset ratio is both low and high, and decreasing its exposure for intermediate cash-to-asset ratios.
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