TY - JOUR
T1 - Under-diversification and idiosyncratic risk externalities
AU - Iachan, Felipe S.
AU - Silva, Dejanir
AU - Zi, Chao
N1 - Funding Information:
We would like to thank Antonio Antunes, Victor Duarte, Bernard Herskovic, Tim Johnson, Mahyar Kargar, Dana Kiku, and seminar/conference participants at the Lubramacro, Lubrafin, UIUC, IDB, Fed Board, FSWF, SED, and SBE meetings. We are particularly grateful to the editor, William Schwert, and two anonymous referees whose invaluable comments significantly contributed to the paper. This study was financed in part by the Coordenação de Aperfeiçoamento de Pessoal de Nível Superior - Brasil (CAPES) - Finance Code 001.
Publisher Copyright:
© 2021 Elsevier B.V.
PY - 2022/3
Y1 - 2022/3
N2 - 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.
AB - 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.
KW - Idiosyncratic risk
KW - Pecuniary externalities
KW - Risk-taking
KW - Under-diversification
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U2 - 10.1016/j.jfineco.2021.05.001
DO - 10.1016/j.jfineco.2021.05.001
M3 - Article
AN - SCOPUS:85107436606
SN - 0304-405X
VL - 143
SP - 1227
EP - 1250
JO - Journal of Financial Economics
JF - Journal of Financial Economics
IS - 3
ER -