On a Connection between Froot-Stein and the De Finetti Optimal Dividends Models

Abstract

Costly external capital is one of the frictions that violates the premises of the Modigliani and Miller irrelevance theorems. Froot et. al. developed a three-stage model to explain how costly external capital, along with other frictions, provides an opportunity for risk management to create value. This paper extends their model to analyze risk management (in particular, reinsurance) in the context of a going concern. It relates the extended Froot model to a fifty-year-old stochastic dividend optimization problem, introduced by Bruno de Finetti, which has received growing interest in the recent decade.