This paper links real investment policy to corporate risk management, endogenizing the costs of external financing.
Previous literature finds investment efficiency linked to full hedging.
In this model, a firm with proprietary information when deciding its investment in a valuable project, may not choose to fully hedge in equilibrium, and this can improve investment efficiency. The size of the project, the hedged value of cash-earnings, and the timing of information revelation, influence the risk management equilibrium. Results are derived under a constraint of no-distress at the time of the investment decision. When this constraint is relaxed, it results in a bargaining situation between shareholders, the counterparty on the contract utilized to manage risk, and new investors. When this occurs investment efficiency is enhanced.