Macroeconomic Risk and Idiosyncratic Risk-Taking

Review of Financial Studies, Forthcoming

73 Pages Posted: 21 Oct 2017 Last revised: 26 Apr 2018

See all articles by Zhiyao Chen

Zhiyao Chen

The Chinese University of Hong Kong (CUHK) - Department of Finance

Ilya A. Strebulaev

Stanford University - Graduate School of Business; National Bureau of Economic Research

Date Written: August 20, 2017

Abstract

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

Chen, Zhiyao and Strebulaev, Ilya A., Macroeconomic Risk and Idiosyncratic Risk-Taking (August 20, 2017). Review of Financial Studies, Forthcoming. Available at SSRN: https://ssrn.com/abstract=3056240

Zhiyao Chen (Contact Author)

The Chinese University of Hong Kong (CUHK) - Department of Finance ( email )

Shatin, N.T.
Hong Kong

Ilya A. Strebulaev

Stanford University - Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States

HOME PAGE: http://faculty-gsb.stanford.edu/strebulaev/

National Bureau of Economic Research ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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