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The microfoundations of hedging and speculative behavior in financial markets
Abstract
The dissertation provides microfoundations for theories of financial instability such as those presented by Hyman Minsky and Charles Kindleberger. The model developed shows that if there are market imperfections, firms may prefer short-term financing strategies. This shift to short-term financing leads to increasing dependence on credit availability and to greater overall financial instability. The model is an extension of current research which shows that under imperfect information, the Modigliani-Miller theorem need not hold and specific optimal financing decisions may be derived. The theoretical model considers a risk neutral firm which chooses between the short (speculative) or long (hedge) financing strategy to finance an investment with a stochastic return. The short financing strategy leads to early liquidation of the firm if it is unable to find future refinancing over the life of the project whereas the long financing strategy protects the firm from early termination. First, it is shown that an optimal debt strategy results if and only if there is a positive probability that in some future states the firm is not refinanced. Separating equilibria are then derived where some firms choose speculative finance while others choose hedge finance. Finally, it is shown that the lender's option to refuse to extend a loan also accounts for positive term premia since long-term financing "locks in" the lender for the entire life of the project.
Subject Area
Finance
Recommended Citation
Lerner, Douglas J, "The microfoundations of hedging and speculative behavior in financial markets" (1991). Doctoral Dissertations Available from Proquest. AAI9207423.
https://scholarworks.umass.edu/dissertations/AAI9207423