Risk Management and the Credit Risk Premium
Posted: 18 Apr 2002
Firms use a variety of different strategies to manage financial risks. This is the case even among firms that face practically identical risk exposures, such as gold mining corporations. This paper develops a theoretical model to show that this diversity can be explained by differences in firms' credit risk premia. If the credit risk premium is relatively small, firms use linear or convex hedging strategies. If the credit risk premium is relatively large, firms use concave hedging strategies. Firms in between those two extremes use strategies that feature both convex and concave elements, e.g. collar strategies. The model replicates essentially all observed hedging strategies in the gold mining industry.
Keywords: Corporate risk management, cost of capital, credit risk, default premium, financing strategies, hedging strategies, security design
JEL Classification: G32
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