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Financial Contracting as Behavior Towards Risk: The Corporate Finance of Business Cycles

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This paper describes an equilibrium macro finance model where contracts are the mechanism by which differentially risk averse bondholders and stockholders resolve a conflict of interest problem and confront the risks associated with future investment decisions and financing decisions of a representative firm/economy. In resolving this conflict of interest problem the interrelated covenants in the financial contract shape certain stylized financial facts of business cycles ignored in classical and Keynesian models. The model set-up includes 2 agents (bondholders and stockholders), 2 decisions (investment and financing decisions), and 2 no-arbitrage equilibrium conditions (market value equals economic book value for both bonds and stocks). In this 2x2x2 set-up it is optimal for the manager of the representative firm to make investment decisions (generating operating income and risk) that conform to the risk aversion of stockholders as reflected in observable stock prices, and then use financing decisions (generating financial risk) to offset any effect of a change in operating risk on the market valuation of bonds. Preliminary evidence from the U.S. nonfinancial corporate sector does not reject the predictions of the model. A similar form of risk and expected return sharing is shown to occur between more risk averse mature and experienced workers with seniority, and less risk averse young apprentice workers.

Author(s):

Robert Krainer    
University of wisconsin-Madison
United States

 

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