Entrepreneurial Finance and Nondiversifiable Risk

Review of Financial Studies, Forthcoming

64 Pages Posted: 27 Mar 2009 Last revised: 7 Jul 2010

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

Multiple version iconThere are 2 versions of this paper

Date Written: July 6, 2010

Abstract

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.

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

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: https://ssrn.com/abstract=1369293

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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