Abstract
We study the effects of idiosyncratic uncertainty on asset prices, investment, and welfare. We consider an economy with two main components: under-diversification and endogenous, countercyclical idiosyncratic risk. The equilibrium is subject to underinvestment and excessive aggregate risk-taking. Inefficiencies stem from an idiosyncratic risk externality, as firms do not internalize the effect of their investment decisions on the risk borne by others. Risk externalities depend on an idiosyncratic risk premium and a variance risk premium. We assess their magnitude empirically. The optimal allocation can be implemented through financial regulation using a tax benefit on debt and risk-weighted capital requirements.
| Original language | English (US) |
|---|---|
| Pages (from-to) | 1227-1250 |
| Number of pages | 24 |
| Journal | Journal of Financial Economics |
| Volume | 143 |
| Issue number | 3 |
| DOIs | |
| State | Published - Mar 2022 |
Keywords
- Idiosyncratic risk
- Pecuniary externalities
- Risk-taking
- Under-diversification
ASJC Scopus subject areas
- Accounting
- Finance
- Economics and Econometrics
- Strategy and Management