Under-diversification and idiosyncratic risk externalities

Felipe S. Iachan; Dejanir Silva; Chao Zi

doi:10.1016/j.jfineco.2021.05.001

Under-diversification and idiosyncratic risk externalities

Felipe S. Iachan, Dejanir Silva, Chao Zi

Finance

Research output: Contribution to journal › Article › peer-review

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	https://doi.org/10.1016/j.jfineco.2021.05.001
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

Online availability

10.1016/j.jfineco.2021.05.001

Library availability

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title = "Under-diversification and idiosyncratic risk externalities",

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.",

keywords = "Idiosyncratic risk, Pecuniary externalities, Risk-taking, Under-diversification",

author = "Iachan, {Felipe S.} and Dejanir Silva and Chao Zi",

note = "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 Coordena{\c c}{\~a}o de Aperfei{\c c}oamento de Pessoal de N{\'i}vel Superior - Brasil (CAPES) - Finance Code 001.",

year = "2022",

month = mar,

doi = "10.1016/j.jfineco.2021.05.001",

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volume = "143",

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journal = "Journal of Financial Economics",

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TY - JOUR

T1 - Under-diversification and idiosyncratic risk externalities

AU - Iachan, Felipe S.

AU - Silva, Dejanir

AU - Zi, Chao

N1 - 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.

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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Under-diversification and idiosyncratic risk externalities

Abstract

Keywords

ASJC Scopus subject areas

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