The Alleviation of Coordination Problems through Financial Risk Management

We characterize a firm as a nexus of activities and projects with their associated cashflow distributions across states of the world and time. With specialized managers intent on maximizing firm value, we show that such a representation leads to a transformation possibility frontier between the riskiness and expected value of cashflows. A firm reacts to changes in the market prices of risks by adjusting its value maximizing portfolio of real activities. We show that financial risk management can help to alleviate the reorganization and coordination problems related to the implementation of the desired adjustments. Empirically, we show that a firm's use of financial derivatives is linked to its reactivity to variations in risk prices. We also argue that financial risk management allows a firm to maintain its value in the presence of cashflow-at-risk or value-at-risk constraints.