Hostname: page-component-77c89778f8-n9wrp Total loading time: 0 Render date: 2024-07-24T03:06:08.590Z Has data issue: false hasContentIssue false
  • English
  • Français

RISK SHOCKS, RISK MANAGEMENT, AND INVESTMENT

Published online by Cambridge University Press:  29 November 2019

Jonathan Goldberg
Jonathan Goldberg*
Affiliation:
Federal Reserve Board
*
Address correspondence to: Jonathan Goldberg, Federal Reserve Board, Mailstop K1-164, 20th Street and Constitution Avenue NW, Washington, DC20551, USA. e-mail: jonathan.goldberg@frb.gov.
Get access Rights & Permissions [Opens in a new window]

Abstract

This paper studies the macroeconomic effects of shocks to idiosyncratic business risk in an economy with endogenously incomplete markets. I develop a model in which firms face idiosyncratic risk and obtain insurance from intermediaries through contracts akin to credit lines. Insurance is imperfect due to limited commitment in financial contracts. Although steady-state capital is higher than if firms were constrained to issue only standard equity, a rise in uncertainty about idiosyncratic business outcomes leads to an endogenous reduction in risk sharing. This deterioration in risk sharing results from a general-equilibrium shortage of pledgeable assets and implies that the economy’s response to an increase in idiosyncratic business risk can be amplified by financial contracting rather than dampened. In a parametrized version of the model, a rise in idiosyncratic business risk generates a large increase in uncertainty about aggregate investment.

Keywords

Endogenously Incomplete MarketsIdiosyncratic RiskAggregate Fluctuations
Type
Articles
Information
Macroeconomic Dynamics , Volume 25 , Issue 7 , October 2021 , pp. 1779 - 1809
Copyright
© Cambridge University Press 2019

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

Footnotes

I am very grateful to two anonymous referees, Marios Angeletos, Nick Bloom, Ricardo Caballero, Giovanni Favara, Guido Lorenzoni, Anna Orlik, Vasia Panousi, Rebecca Wasyk, and Iván Werning for their helpful suggestions. I also would like to thank the seminar participants at ESEM 2017, Boston College, Boston University, the University of California-Berkeley (Haas), MIT, the University of Maryland (Smith), the University of Michigan, the World Bank, the Federal Reserve Banks of Kansas City, New York and Richmond, and conferences. I gratefully acknowledge the financial support from the Kauffman Foundation. The views expressed here are those of the author and need not represent the views of the Federal Reserve Board or its staff.

References

REFERENCES

Albuquerque, R., Eichenbaum, M., Luo, V. X. and Rebelo, S. (2016) Valuation risk and asset pricing. The Journal of Finance 71(6), 2861–2904.10.1111/jofi.12437CrossRefGoogle Scholar
Angeletos, G.-M. (2007) Uninsured idiosyncratic investment risk and aggregate saving. Review of Economic Dynamics 10(1), 1–30.10.1016/j.red.2006.11.001CrossRefGoogle Scholar
Angeletos, G.-M. and Calvet, L.-E. (2006) Idiosyncratic production risk, growth and the business cycle. Journal of Monetary Economics 53(6), 1095–1115.10.1016/j.jmoneco.2005.05.016CrossRefGoogle Scholar
Angeletos, G.-M. and Panousi, V. (2009) Revisiting the supply side effects of government spending. Journal of Monetary Economics 56(2), 137–153.10.1016/j.jmoneco.2008.12.010CrossRefGoogle Scholar
Angeletos, G.-M. and Panousi, V. (2011) Financial integration, entrepreneurial risk and global dynamics. Journal of Economic Theory 146(3), 863–896.10.1016/j.jet.2011.02.001CrossRefGoogle Scholar
Arellano, C., Bai, Y. and Kehoe, P. J. (2018) Financial Frictions and Fluctuations in Volatility. Federal Reserve Bank of Minneapolis Research Department Staff Report.10.21034/sr.466CrossRefGoogle Scholar
Bachmann, R. and Bayer, C. (2013) ‘Wait-and-See’ business cycles? Journal of Monetary Economics 60(6), 704–719.10.1016/j.jmoneco.2013.05.005CrossRefGoogle Scholar
Bansal, R., Kiku, D. and Yaron, A. (2016) Risks for the long run: Estimation with time aggregation. Journal of Monetary Economics 82, 52–69.10.1016/j.jmoneco.2016.07.003CrossRefGoogle Scholar
Bassett, W. F., Gilchrist, S., Weinbach, G. C. and Zakrajšek, E. (2012) Improving our ability to monitor bank lending. In: Brunnermeier, M. and Krishnamurthy, A. (eds.), Risk Topography: Systemic Risk and Macro Modeling, pp. 149–161. Chicago: University of Chicago Press.Google Scholar
Benhabib, J., Bisin, A. and Zhu, S. (2011) The distribution of wealth and fiscal policy in economies with finitely lived agents. Econometrica 79(1), 123–157.Google Scholar
Bigio, S. (2015) Endogenous liquidity and the business cycle. The American Economic Review 105(6), 1883–1927.10.1257/aer.20110035CrossRefGoogle Scholar
Bloom, N. (2009) The impact of uncertainty shocks. Econometrica 77(3), 623–685.Google Scholar
Bloom, N., Floetotto, M., Jaimovich, N., Saporta-Eksten, I. and Terry, S. J. (2018) Really uncertain business cycles. Econometrica 86(3), 1031–1065.10.3982/ECTA10927CrossRefGoogle Scholar
Braun, R. A. and Nakajima, T. (2012) Uninsured countercyclical risk: An aggregation result and application to optimal monetary policy. Journal of the European Economic Association 10(6), 1450–1474.10.1111/j.1542-4774.2012.01091.xCrossRefGoogle Scholar
Buera, F. J., Kaboski, J. P. and Shin, Y. (2011) Finance and development: A tale of two sectors. The American Economic Review, 101(5), 1964–2002.10.1257/aer.101.5.1964CrossRefGoogle Scholar
Caldara, D., Fernandez-Villaverde, J., Rubio-Ramirez, J. F. and Yao, W. (2012) Computing DSGE models with recursive preferences and stochastic volatility. Review of Economic Dynamics 15(2), 188–206.10.1016/j.red.2011.10.001CrossRefGoogle Scholar
Chen, H., Miao, J. and Wang, N. (2010) Entrepreneurial finance and nondiversifiable risk. Review of Financial Studies 23(12), 4348–4388.10.1093/rfs/hhq122CrossRefGoogle Scholar
Chetty, R., Guren, A., Manoli, D. and Weber, A. (2011) Are micro and macro labor supply elasticities consistent? A review of evidence on the intensive and extensive margins. The American Economic Review 101(3), 471–475.10.1257/aer.101.3.471CrossRefGoogle Scholar
Christiano, L., Motto, R. and Rostagno, M. (2014) Risk shocks. The American Economic Review 104(1), 27–65.10.1257/aer.104.1.27CrossRefGoogle Scholar
Chugh, S. K. (2016) Firm risk and leverage-based business cycles. Review of Economic Dynamics 20, 111–131.10.1016/j.red.2016.02.001CrossRefGoogle Scholar
Dávila, J., Hong, J. H., Krusell, P. and Ríos-Rull, J.-V. (2012) Constrained efficiency in the neoclassical growth model with uninsurable idiosyncratic shocks. Econometrica 80(6), 2431–2467.Google Scholar
DeBacker, J., Panousi, V. and Ramnath, S. (2015) The Properties of Business Income Risk. Mimeo, Federal Reserve Board.Google Scholar
Demiroglu, C. and James, C. (2011) The use of bank lines of credit in corporate liquidity management: A review of empirical evidence. Journal of Banking & Finance 35(4), 775–782.10.1016/j.jbankfin.2010.10.020CrossRefGoogle Scholar
De Santis, M. (2007) Individual consumption risk and the welfare cost of business cycles. American Economic Review 97(4), 1488–1506.10.1257/aer.97.4.1488CrossRefGoogle Scholar
Froot, K. A., Scharfstein, D. S. and Stein, J. C. (1993) Risk management: Coordinating corporate investment and financing policies. The Journal of Finance 48(5), 1629–1658.10.1111/j.1540-6261.1993.tb05123.xCrossRefGoogle Scholar
Gilchrist, S., Sim, J. W. and Zakrajšek, E. (2014) Uncertainty, Financial Frictions, and Investment Dynamics. National Bureau of Economic Research Working Paper: No. 20038.10.3386/w20038CrossRefGoogle Scholar
Glover, B. and Levine, O. (2015) Uncertainty, investment, and managerial incentives. Journal of Monetary Economics 69, 121–137.10.1016/j.jmoneco.2014.11.004CrossRefGoogle Scholar
Gopalan, R., Milbourn, T. and Song, F. (2010) Strategic flexibility and the optimality of pay for sector performance. The Review of Financial Studies 23(5), 2060–2098.10.1093/rfs/hhp118CrossRefGoogle Scholar
Gourio, F. (2012) Disaster risk and business cycles. American Economic Review 102(6), 2734–2766.10.1257/aer.102.6.2734CrossRefGoogle Scholar
Graham, J. R., Harvey, C. R. and Puri, M. (2013) Managerial attitudes and corporate actions. Journal of Financial Economics 109(1), 103–121.10.1016/j.jfineco.2013.01.010CrossRefGoogle Scholar
Gruber, J. (2013) A tax-based estimate of the elasticity of intertemporal substitution. The Quarterly Journal of Finance 3(1), 1–20.10.1142/S2010139213500018CrossRefGoogle Scholar
Guvenen, F. (2006) Reconciling conflicting evidence on the elasticity of intertemporal substitution: A macroeconomic perspective. Journal of Monetary Economics 53(7), 1451–1472.10.1016/j.jmoneco.2005.06.001CrossRefGoogle Scholar
Hall, B. J. and Liebman, J. B. (1998) Are CEOs really paid like bureaucrats? Quarterly Journal of Economics 113(3), 653–691.10.1162/003355398555702CrossRefGoogle Scholar
Hall, R. E. (1988) Intertemporal substitution in consumption. The Journal of Political Economy 96(2), 339–357.10.1086/261539CrossRefGoogle Scholar
Herskovic, B., Kelly, B., Lustig, H. and Van Nieuwerburgh, S. (2015) The common factor in idiosyncratic volatility: Quantitative asset pricing implications. Journal of Financial Economics 119, 249–283.10.1016/j.jfineco.2015.09.010CrossRefGoogle Scholar
Holmström, B. and Tirole, J. (1998) Private and public supply of liquidity. The Journal of Political Economy 106(1), 1–40.10.1086/250001CrossRefGoogle Scholar
Jermann, U. and Quadrini, V. (2012) Macroeconomic effects of financial shocks. The American Economic Review 102(1), 238–271.10.1257/aer.102.1.238CrossRefGoogle Scholar
Johnson, D. S., Parker, J. A. and Souleles, N. S. (2006) Household expenditure and the income tax rebates of 2001. The American Economic Review 96(5), 1589–1610.10.1257/aer.96.5.1589CrossRefGoogle Scholar
Kartashova, K. (2014) Private equity premium puzzle revisited. The American Economic Review 104(10), 3297–3334.10.1257/aer.104.10.3297CrossRefGoogle Scholar
Letendre, M.-A. and Wagner, J. (2018) Agency costs, risk shocks, and international cycles. Macroeconomic Dynamics 22(5), 1134–1172.10.1017/S1365100516000614CrossRefGoogle Scholar
Lorenzoni, G. (2008) Inefficient credit booms. The Review of Economic Studies 75(3), 809–833.10.1111/j.1467-937X.2008.00494.xCrossRefGoogle Scholar
Luo, Y., Gong, L. and Zou, H.-f. (2010) A note on entrepreneurial risk, capital market imperfections, and heterogeneity. Macroeconomic Dynamics 14(2), 269–84.10.1017/S1365100509090245CrossRefGoogle Scholar
Meh, C. A. and Quadrini, V. (2006) Endogenous market incompleteness with investment risks. Journal of Economic Dynamics and Control 30(11), 2143–2165.10.1016/j.jedc.2005.02.008CrossRefGoogle Scholar
Murphy, K. J. (1999) Executive compensation. Handbook of Labor Economics 3, 2485–2563.10.1016/S1573-4463(99)30024-9CrossRefGoogle Scholar
Nuño, G. and Moll, B. (2018) Social optima in economies with heterogeneous agents. Review of Economic Dynamics 28, 150–180.10.1016/j.red.2017.08.003CrossRefGoogle Scholar
Panousi, V. and Reis, C. (2015) Optimal Capital Taxation with Idiosyncratic Investment Risk. Mimeo, Federal Reserve Board.Google Scholar
Panousi, V. and Papanikolaou, D. (2012) Investment, idiosyncratic risk, and ownership. Journal of Finance 67(3), 1113–1148.10.1111/j.1540-6261.2012.01743.xCrossRefGoogle Scholar
Rampini, A. A. (2004) Entrepreneurial activity, risk, and the business cycle. Journal of Monetary Economics 51(3), 555–573.10.1016/j.jmoneco.2003.06.003CrossRefGoogle Scholar
Rampini, A. A., Sufi, A. and Viswanathan, S. (2014) Dynamic risk management. Journal of Financial Economics 111(2), 271–296.10.1016/j.jfineco.2013.10.003CrossRefGoogle Scholar
Rasmusen, E. (2007) When does extra risk strictly increase an option’s value? Review of Financial Studies 20(5), 1647–1667.10.1093/rfs/hhm028CrossRefGoogle Scholar
Roussanov, N. and Savor, P. (2014) Marriage and managers’ attitudes to risk. Management Science 60(10), 2496–2508.10.1287/mnsc.2014.1926CrossRefGoogle Scholar
Sandri, D. (2014) Growth and capital flows with risky entrepreneurship. American Economic Journal: Macroeconomics 6(3), 102–123.Google Scholar
Stulz, R. M. (1984) Optimal hedging policies. Journal of Financial and Quantitative Analysis 19(2), 127–140.10.2307/2330894CrossRefGoogle Scholar