PDF Ebook Does Idiosyncratic Business Risk Matter?
In standard Arrow-Debreu economies with complete markets, idiosyncratic risk can be fully diversified away and it is irrelevant for equilibrium outcomes. But as emphasized by Townsend (1978) and Holmstrom (1979), among others, full risk diversification is costly and much theoretical research has analyzed how various forms of financial frictions can prevent it, hampering aggregate productivity, output, and capital accumulation as in, for example, Greenwood & Jovanovic (1990), Bencivenga & Smith (1991), Acemoglu & Zilibotti (1997), and Meh & Quadrini (2006). More recently Angeletos (2007) and Castro, Clementi & MacDonald (2004) have instead shown that the presence of undiversified risk can stimulate savings–because of either precautionary motives, or an increase in entrepreneurial earnings—and can foster growth.
Despite much theoretical interest, there has been little empirical analysis of the effects of idiosyncratic risk on growth. A key issue in identifying the effects of idiosyncratic risk is that the volatility of observed growth or of any other economic outcome (in brief observed risk) could be a (very) imperfect measure of the true underlying risk, which determines institutional arrangements and shapes agents’ decisions. For example principal agent models as in Holmstrom & Milgrom (1987) show that a trade off generally exists between risk-sharing benefits and provision of incentives and as a result observed risk only indirectly measures underlying risk. More recently, Aghion, Angeletos, Banerjee & Manova (2007), Thesmar & Thoenig (2000), and Thesmar & Thoenig (2004) have also stressed that observed risk is endogenous to the market structure and to the risk diversification opportunities available in the economy, since firms react to changes in the economic environment by modifying their organization structure and their innovation activities. Fischer (2008) provides experimental evidence that financial arrangements directly affect entrepreneurs’ risk taking behavior.
In this paper we provide evidence on the effects of idiosyncratic risk on growth. To analyze the issue we consider a simple extension of the moral hazard model by Holmstrom & Tirole (1997) where risk averse entrepreneurs canchoose between projects with different risk-returns tradeoffs. To solve the ensuing agency problem (which is a source of financial frictions), entrepreneurs have to partly finance the business venture with their own wealth and so idiosyncratic business risk cannot be fully diversified away.1 Because of this, entrepreneurs may choose projects that are strictly dominated from the point of view of a well diversified portfolio, just because they have a lower idiosyncratic risk. This hinders innovation, entrepreneurial activity, and growth. The model delivers two key predictions that would be common to a vast class of models: first, the effects of idiosyncratic risk on growth strictly depend on the degree of financial market imperfections and risk diversification opportunities—with zero effects for low enough financial frictions and negative and increasing effects as frictions become sufficiently large; second, the observed volatility of the projects’ returns is endogenous with respect to diversification opportunities, as entrepreneurs can endogenously reduce risk by choosing safer, more conservative projects.
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