The Importance of Financial Leverage and Risk Aversion in Risk-Management Strategy Selection

The problem of choice among risk-management strategies is addressed with the stochastic dominance with a risk-free asset (SDRA) criteria. The SDRA criteria consider all possible combinations of the strategies and financial leverage. This allows for strategies with less business risk, less expected return, and greater leverage to dominate strategies with greater business risk and greater expected return. Results show that the inclusion of the risk-free asset significantly improves the discriminatory power of the ordinary stochastic dominance criteria for the case of risk-management strategies. Copyright 2002, Oxford University Press.