“A Theory of Liquidity and Risk Management Based on Inalienability of Risky Human Capital” by Neng Wang
Shanghai University of Finance and Economics
We analyze a dynamic optimal financial contracting problem in continuous time with risky cash flows between a risk-averse entrepreneur and risk-neutral investors. Two fundamental constraints on the contracting parties are that: 1) the entrepreneur cannot alienate his human capital, and 2) investors have limited liability protection. Given that human capital is risky, the entrepreneur's inability to commit his human capital to the firm generates significant distortions for risk-sharing, corporate investment, and consumption. We show that the optimal contracting problem boils down to a corporate liquidity and risk-management problem for the firm. We also show that equilibrium default on a credit line is optimal when firms face persistent productivity shocks. Finally, we quantitatively value the net benefits of risk and liquidity management and find that they are high. Our analysis thus provides new foundations for liquidity and risk management policies that firms routinely pursue in practice.