Dynamic financing and hedging under model uncertainty

Abstract

ABSTRACT We extend the classic framework to investigate a firm's optimal financing, investment, payout and hedging strategies under model uncertainty (or ambiguity). It shows that model uncertainty has essentially different effects on liquidity policies compared to traditional business risk. A firm facing model uncertainty prefers refinancing less and payout earlier, and the marginal value may be increased when the refinancing option is in the money. Moreover, our model demonstrates that hedging tools play an important role in mitigating the negative impacts on firm value caused by model uncertainty, which illustrates an interesting result that traditional risk management method works well not only on business risk but also on model uncertainty.