Risk-Adjusted Capital Allocation and Misallocation

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: costs of business cycles, cross-section of returns, Misallocation, time-varying risk premia