Extrapolation Bias and Robust Dynamic Liquidity Management
48 Pages Posted: 13 Dec 2018 Last revised: 23 Mar 2020
Date Written: January 10, 2019
We consider the optimal dynamic liquidity management of a financially constrained firm when its manager is risk-neutral but ambiguity-averse with respect to the firm’s future cash flows. Managerial ambiguity-aversion generates endogenous time-varying worst-case beliefs that overweight recent cash flow realizations, thereby providing a microeconomic foundation for managerial extrapolation bias. Moreover, managerial ambiguity-aversion has different implications on firms’ liquidity management and recapitalization policies than risk. Models with risk alone imply that higher cash flow volatility increases firms’ payout and refinancing thresholds. By contrast, our model predicts that when ambiguity-averse managers face a higher long-term cash flow uncertainty, they optimally reduce firms’ payout and refinancing thresholds. Implications for investment and implied ambiguity premia are also studied.
Keywords: Ambiguity-Aversion, Extrapolation Bias, Liquidity Management, Investment, Risk Management, Permanent and Temporary Shocks
JEL Classification: G31, G32, G35, D81
Suggested Citation: Suggested Citation