Corporate Policies and the Term Structure of Risk

Abstract

We introduce heterogeneity in the pricing of aggregate risks of various persistence into a dynamic corporate finance model with financing frictions. We show that if long-term (persistent) shocks have a higher market price than short-term (temporary) shocks, firms shorten the horizon of corporate policies, increasing payouts and reducing investment, keeping less precautionary cash, and favoring asset sales to outside financing when financial constraints tighten. The analysis is extended to allow for heterogeneous firm's exposure to these risks and to embed time variation in their risk prices. Our model demonstrates that accounting for the term structure of risk prices is key to devise optimal real and financial policies.

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

JEL Classification: G12, G31, G32, G35