Corporate Policies and the Term Structure of Risk

Abstract

The relative pricing of short-term (transitory) versus long-term (persistent) risks is a key, yet overlooked, aspect of firms' intertemporal decisions. In a dynamic model with financing frictions, we show that firms should extend their horizon if short-term shocks have a greater market price than long-term ones. Ignoring this relative pricing leads to distorted policies that overweight the short-term, including excessive payouts, underinvestment, lower-than-optimal equity issuances and precautionary savings, and excessive disinvestment when constraints tighten. The analysis is extended to allow for heterogeneous firm exposure to these risks and time variation in their risk prices, consistent with the evidence.

Keywords: Pricing of aggregate risks, Horizon of corporate policies, Temporary vs. permanent shocks

JEL Classification: G12, G31, G32, G35