Macroeconomic Risk and Idiosyncratic Risk-Taking
Review of Financial Studies, Forthcoming
73 Pages Posted: 21 Oct 2017 Last revised: 26 Apr 2018
Date Written: August 20, 2017
We develop and estimate a dynamic model of risk-shifting over the business cycle. First, equity holders with Epstein-Zin preferences increase their taking of idiosyncratic risk substantially more than the standard model in repeated games, because they perceive the arrival probability of bad states higher than the actual probability and prefer an early resolution of macroeconomic uncertainty. Second, sudden switches to bad states and large shocks in the bad states induce the countercyclical and "synchronized'' idiosyncratic risk. Third, combined with high market risk premium in the bad states, the clustered risk-taking generates the countercyclical idiosyncratic volatility discount on equity returns.
Keywords: risk-shifting, macroeconomic risk, business cycle, agency conflicts, bankruptcy, financial leverage, simulated method of moments, idiosyncratic volatility puzzle
JEL Classification: G12, G32
Suggested Citation: Suggested Citation