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Entrepreneurial Finance and Nondiversifiable Risk

Hui Chen

Massachusetts Institute of Technology; National Bureau of Economic Research (NBER)

Jianjun Miao

Boston University - Department of Economics

Neng Wang

Columbia Business School - Finance and Economics

July 6, 2010

Review of Financial Studies, Forthcoming

We develop a dynamic incomplete-markets model of entrepreneurial firms, and demonstrate the implications of non-diversifiable risks for entrepreneurs’ interdependent consumption, portfolio allocation, financing, investment, and business exit decisions. We characterize the optimal capital structure via a generalized tradeoff model where risky debt provides significant diversification benefits. Non-diversifiable risks have several important implications: more riskaverse entrepreneurs default earlier, but choose higher leverage; lack of diversification causes entrepreneurial firms to underinvest relative to public firms, and risky debt partially alleviates this problem; entrepreneurial risk aversion can overturn the risk-shifting incentives induced by risky debt. We also analytically characterize the idiosyncratic risk premium.

Number of Pages in PDF File: 64

Keywords: default, diversification benefits, entrepreneurial risk aversion, incomplete markets, idiosyncratic risk premium, hedging, capital structure, cash-out option, precautionary saving

JEL Classification: G11, G31, E2

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Date posted: March 27, 2009 ; Last revised: July 7, 2010

Suggested Citation

Chen, Hui and Miao, Jianjun and Wang, Neng, Entrepreneurial Finance and Nondiversifiable Risk (July 6, 2010). Review of Financial Studies, Forthcoming. Available at SSRN: http://ssrn.com/abstract=1369293

Contact Information

Hui Chen (Contact Author)
Massachusetts Institute of Technology ( email )
50 Memorial Drive
Cambridge, MA 02142
United States
617-324-3896 (Phone)
National Bureau of Economic Research (NBER) ( email )
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Jianjun Miao
Boston University - Department of Economics ( email )
270 Bay State Road
Boston, MA 02215
United States
617-353-6675 (Phone)
HOME PAGE: http://people.bu.edu/miaoj
Neng Wang
Columbia Business School - Finance and Economics ( email )
3022 Broadway
New York, NY 10027
United States

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