Optimal risk-taking in corporate defined benefit plans under risk-shifting

Abstract

PurposeThe purpose of this paper is to theoretically examine the risk-taking decision of corporate defined benefits (DB) plans. The equity holders’ investment problem that is represented by the position of a vulnerable option is solved.Design/methodology/approachThe simple traditional contingent claim approach is applied, which considers only the distributions of corporate cash flow, without the model expansions, such as market imperfections, needed to explain the firms’ behavior for DB plans in previous studies.FindingsThe authors find that the optimal solution to the equity holders’ DB investment problem is not an extreme corner solution such as 100 percent investment in equity funds as in the literature. Rather, the solution lies in the middle range, as is commonly observed in real-world economies.Originality/valueThe major value of this study is that it develops a clear mechanism for obtaining an internal solution for the equity holders’ DB investment problem and it provides the understanding that the base for corporate investment behavior for DB plans should incorporate the fact that in some cases the optimal solution is in the middle range. Therefore, the corporate risk-taking behavior of DB plans is harder to identify than the results of the empirical literature have predicted.