Under-diversification and idiosyncratic risk externalities

Felipe S. Iachan, Dejanir Silva, Chao Zi

Research output: Contribution to journalArticlepeer-review


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 languageEnglish (US)
Pages (from-to)1227-1250
Number of pages24
JournalJournal of Financial Economics
Issue number3
StatePublished - Mar 2022


  • Idiosyncratic risk
  • Pecuniary externalities
  • Risk-taking
  • Under-diversification

ASJC Scopus subject areas

  • Accounting
  • Finance
  • Economics and Econometrics
  • Strategy and Management


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