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

Abstract

This paper describes a parsimonious 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 and financing decisions of a representative firm/economy. In resolving this conflict of interest problem the interrelated covenants in the bond contract shape certain financial facts ignored in other models of the business cycle. A change in risk aversion or perception of risk changes the market valuations of their securities and has the representative firm adjusting both sides of their balance sheet. The asset adjustments potentially cause business cycles while the financing adjustment is designed to offset any risk shifting effects on the market valuation of bonds. The model set-up includes 2 investors (bondholders and stockholders), 2 decisions (investment and financing decisions), and 2 equilibrium conditions (market values equal economic book values for both bonds and stocks). Starting from an initial equilibrium where market value equals book value, a cyclical expansion is set in motion by a shock induced reduction in risk aversion of stockholders that increases stock valuations above economic book valuations. The representative firm responds with an expansionary and risky asset adjustment decision which because it is risky reduces bond valuations. The contract then calls upon the representative firm to finance the expansion with equity reducing financial leverage and financial risk restoring bond valuations to their economic book value. A similar form of risk and return sharing is shown to occur between risk averse and mature and experienced workers and less risk averse young apprentice workers. Older and more experienced risk averse workers like bondholders opt for the safety of seniority arrangements and pay for it with a required wage rate below their marginal value product. Young and less risk averse workers like stockholders require a wage higher than their marginal value product to accept the increased variability in their employment that comes from granting seniority to the more mature workers.

Keywords: Covenants, Investment Decisions, Business Cycles, Financing Decisions, Financial Markets, Labor Market

JEL Classification: D7, E0, G1, G3, K0, L2