Extrapolation Bias and Robust Dynamic Liquidity Management

48 Pages Posted: 13 Dec 2018 Last revised: 23 Mar 2020

See all articles by Seokwoo Lee

Seokwoo Lee

University of Michigan at Ann Arbor, Stephen M. Ross School of Business, Finance; George Mason University, School of Business - Finance Area

Alejandro Rivera

University of Texas at Dallas - School of Management - Department of Finance & Managerial Economics

Date Written: January 10, 2019

Abstract

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

Lee, Seokwoo and Rivera, Alejandro, Extrapolation Bias and Robust Dynamic Liquidity Management (January 10, 2019). Available at SSRN: https://ssrn.com/abstract=3282386 or http://dx.doi.org/10.2139/ssrn.3282386

Seokwoo Lee

University of Michigan at Ann Arbor, Stephen M. Ross School of Business, Finance ( email )

701 Tappan Street
Ann Arbor, MI 48109-1234
United States

George Mason University, School of Business - Finance Area ( email )

Fairfax, VA 22030
United States
7039935163 (Phone)

HOME PAGE: http://www-personal.umich.edu/~seokwoo

Alejandro Rivera (Contact Author)

University of Texas at Dallas - School of Management - Department of Finance & Managerial Economics ( email )

2601 North Floyd Road
P.O. Box 830688
Richardson, TX 75083
United States

HOME PAGE: http://jindal.utdallas.edu/faculty/alejandro-rivera

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