Risk Sharing Within and Outside the Firm

Abstract

We study the interrelation between two types of risk sharing -- within firms and on capital markets -- by analyzing the effect of wrongful-discharge laws (WDLs) on stock returns. The effects of WDLs on returns reflect how shareholders and workers share systematic risk via flexible wages and employment. This state-contingent allocation of income between labor and capital differs substantially depending on the design of the WDLs. When WDLs address agency frictions and prohibit employers from holding up employees by firing them, workers bear more firm risk via variable compensation and expected returns are lower. Legislation that raises firing costs without addressing holdup only makes employment more sticky with workers bearing less risk and higher expected returns.

Keywords: Employment protection, expected stock returns, risk sharing, agency frictions

JEL Classification: G12, J38, G38