| Abstract: |
This paper examines the choice of tools for managing a firm’s operational
risks: cash reserves, insurance contracts, and financial assets under an
optimal financing contract that solves moral hazard between insiders and
outside investors. Risk management is valuable as it reduces the costs of
raising external financing, increases debt capacity, lessens underinvestment,
and improves welfare. I show that insurance is superior as it facilitates the
outside financing relationship but leads to inefficient excessive continuation
if used without coverage limits. When insurance against an operational risk is
not available, the firm uses financial assets instead or resorts to holding
cash reserves. |