Corporate Policies and the Term Structure of Risk
66 Pages Posted: 26 Jun 2020 Last revised: 29 Aug 2023
Date Written: June 15, 2020
Abstract
Asset pricing research indicates that the long and short term do not contribute equally to the market risk premium, and that their relative contribution is time-varying. While having notable implications for firm discount rates, corporate finance models typically abstract from these aspects. In a dynamic model with financing frictions, we show that firms should extend (shorten) their horizon if short-term shocks have a greater (smaller) market price than long-term ones, i.e., if the term structure of risk prices is downward-sloping (upward-sloping). Ignoring a downward-sloping term structure leads to underinvestment, excessive payouts, inadequate cash reserves and equity issuances, and excessive liquidations.
Keywords: Horizon of corporate policies; Term structure of risk; Temporary vs.\ permanent shocks
JEL Classification: G12, G31, G32, G35
Suggested Citation: Suggested Citation