Liquidity and Risk Management with Ambiguity

Abstract

We formulate a robust theory of liquidity and risk management based on two fundamental frictions: 1) the entrepreneur cannot alienate his human capital, and 2) the entrepreneur worries about model uncertainty and seek robust decisions. In line with max-min expected utility, a robust entrepreneur makes decisions under some endogenous worst case, which generates significant distortions for risk-sharing, corporate investment, and consumption. With regard to concern for ambiguity aversion, the entrepreneur optimally responds by lowering the maximal debt capacity, under-investing and under-consuming. However, the impacts of ambiguity on risk hedging is ambiguous due to the interactions between robustness and limited commitment constraints. These distortions are greater the more financially constrained the firm is. Furthermore, we show that the optimal consumption rule is no longer deterministic but stochastic when taking the preference for robustness into account. Implications for implied ambiguity premium and persistent productivity shocks are also studied.