Idiosyncratic Investment Risk and Business Cycles

Abstract

I show that, due to imperfect risk sharing, aggregate shocks to uncertainty about idiosyncratic return on investment generate economic contractions with elevated risk premia and a decrease in the risk-free rate. I present a tractable real business cycle model in which firms experience idiosyncratic shocks, to which managers are at least partially exposed; the distribution of these shocks is time-varying and stochastic. I show that the path for aggregate quantities, the price of physical capital, and the equity premium are the same as in a model without idiosyncratic risk, but with time-preference shocks. That is, in response to an increase in idiosyncratic uncertainty, the response of these variables is the same as if there were no idiosyncratic uncertainty but managers were suddenly reluctant to invest. However, time-preference and idiosyncratic uncertainty shocks are not isomorphic: an increase in idiosyncratic uncertainty leads to greater demand for precautionary saving and hence a decrease in the risk-free rate; in contrast, an increase in impatience has the opposite effect. In addition, with an idiosyncratic uncertainty shock, investment in physical capital can remain low even after the stock market and firm profitability recover, because managers cannot fully transfer idiosyncratic risk to diversified investors. Thus, shocks to idiosyncratic investment risk can explain, qualitatively, the aftermath of financial panics -- elevated risk premia, a sharp and persistent decrease in investment, and a decrease in the risk-free rate. In a calibration, an increase in idiosyncratic investment risk similar to that experienced during the Great Recession leads firms to invest as if their cost of capital were 10 percentage points higher than the cost of capital implied by financial markets, and to a large decrease in the real risk-free rate.

Keywords: incomplete markets, idiosyncratic risk, business cycles, equity premium, risk-free rate

JEL Classification: D52, E44, G11