Risk-Adjusted Capital Allocation and Misallocation

75 Pages Posted: 18 Oct 2018

See all articles by Joel David

Joel David

University of Southern California

Lukas Schmid

University of Southern California - Marshall School of Business

David Zeke

University of Southern California - Department of Economics

Multiple version iconThere are 2 versions of this paper

Date Written: September 25, 2018

Abstract

We develop a theory linking “misallocation,” i.e., dispersion in static marginal products of capital (MPK), to systematic investment risks. In our setup, firms differ in their exposure to these risks, which we show leads naturally to heterogeneity in firm-level risk premia and, more importantly, MPK. The theory predicts that cross-sectional dispersion in MPK (i) depends on cross-sectional dispersion in risk exposures and (ii) fluctuates with the price of risk, and thus is countercyclical. We document strong empirical support for these predictions. We devise a strategy to quantify variation in firm-level risk exposures using data on the dispersion of expected stock market returns. Our estimates imply that risk considerations explain almost 40% of observed MPK dispersion among US firms and in particular, can rationalize a large persistent component in firm-level MPK deviations. Our framework provides a sharp link between aggregate volatility, cross-sectional asset pricing and long-run economic performance – MPK dispersion induced by risk premium effects, although not prima facie inefficient, lowers the average level of aggregate TFP by as much as 7%, suggesting large “productivity costs” of business cycles.

Keywords: Misallocation, Costs of Business Cycles, Cross-Section of Returns, Time-Varying Risk Premia

JEL Classification: D25, E32, G12, O47

Suggested Citation

David, Joel and Schmid, Lukas and Zeke, David, Risk-Adjusted Capital Allocation and Misallocation (September 25, 2018). Available at SSRN: https://ssrn.com/abstract=3255111 or http://dx.doi.org/10.2139/ssrn.3255111

Joel David

University of Southern California ( email )

2250 Alcazar Street
Los Angeles, CA 90089
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Lukas Schmid (Contact Author)

University of Southern California - Marshall School of Business ( email )

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Los Angeles, CA California 90089-1424
United States

David Zeke

University of Southern California - Department of Economics ( email )

3620 South Vermont Ave. Kaprielian (KAP) Hall, 300
Los Angeles, CA 90089
United States

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