This paper makes contributions in two directions. First, the paper presents a model in which value-maximizing firms pursue active hedging policies. Second, the paper derives optimal hedging policies for risk-averse agents. Whereas the methodology used and the results provided are quite general, this paper deliberately focuses the analysis on hedging foreign exchange exposure through forward contracts on foreign currencies. This emphasis is explained by the fact that hedging foreign currency exposure through forward contracts has been a topic of considerable interest in recent years.

The group of issues that falls under the heading of bank capital adequacy has received a great deal of attention from academics, regulators, and bankers in recent years and is likely to continue as a subject for debate for many years to come. Although the traditional questions debated in the literature on capital adequacy are important and remain unresolved, this paper is not directed at them. Instead, the approach here is to examine how bank regulators operating within the existing legal structure of regulation can pursue optimal policies with respect to the regulation of bank capital.

One of the main principles of corporate finance is that managers should maximize the market value of the outstanding securities. While it is realized that managers and security holders may have divergent objectives, it is generally assumed that various market forces keep managerial and shareholders' goals in line. Out of the extensive literature on this issue, three such market forces emerge. First, non-value-maximizing firms are prime targets for take-over bids (e.g., see [14]): bidding firms could acquire control over the shares of the target firm, replace the management, follow a value-maximizing strategy, and realize a profit from the resulting appeciation of the target shares. Second, outside shareholders may charge managers-owners ex ante by discounting stock prices for expected managerial expropriation, which may induce managers to accept various restrictions on their behavior (e.g., see [11]). Third, shareholders may charge managers ex post, indirectly via the discipline imposed by a competitive managerial labor market (e.g., [8]). Note the difference from the previous mechanism: Jensen and Meckling [11] assume that managerial wages are fixed so that all the adjustment for expected expropriation is reflected in stock prices (and, ultimately, in costly monitoring and bonding devices). In Fama's [8] model, all the adjustment occurs in the managerial labor market, so that the value of the firm remains unaffected by expected managerial expropriation.

Controversy surrounds the Securities and Exchange Commission's (SEC) Rule 415 that went into effect in March 1982 and remained an experiment until it was permanenty adopted for large firms in November 1983. Rule 415allows a company to register all the securities it plans to issue over the next two years and then to sell someor all of the securities whenever it chooses. This procedure is known as a shelf registration. The purposes of Rule 415 are to simplify the registration of new corporate securities and to allow more flexibility in the way issues are underwritten.

The “information content of dividends” hypothesis (which emanates from the early work of Lintner [17] and Miller and Modigliani [18]) states that managers use dividend announcements to signal their beliefs about the prospects of the firm. Thus, an announcement of an increase in the dividend rate reflects management's belief that the firm's cash flows in the foreseeable future will be sufficiently high to sustain payment at the increased rate. Similarly, an announcement of a dividend decrease occurs only when management is extremely pessimistic about the probability that future cash flows will be sufficient to continue dividends at their present rate. The theoretical implication of the “information content” hypothesisis that the announcement of a dividend (or change in dividend) conveys information about management's assessment of the firm's prospects, that this information is different from other information provided by management, and this information may cause an immediate investor reaction, including, but not limited to, price changes.

The capital asset pricing model of Sharpe [39], Lintner [28], and Mossin [33] has been the basis for many theoretical and empirical studies in capital markets. One criticism of the model hasbeen directed at the assumption that investors optimize in a one-period framework. Fama [7] and Merton [30] have shown that the results of this one-period optimization model are consistent with the results for an intertemporal optimization model if the investment opportunity set is constant over time. Specifically, the relevant parameters for the distributions of risky securities (i.e., conditional means and variances) must be constant over time. Merton has argued that this is a restrictive assumption, but there has been very little empirical evidence to suggest that changes in the investment opportunity set are significant.

Geske derived in [1] expressions for the values of junior and senior debt and equity. In this paper, some confusion about these expressions is cleared up, and an error is corrected. We use the same notation as in [1].