Feedback Effects with Risk Aversion: An Application to Climate Risk

Abstract

We study the implications of the “feedback effect” when a firm’s investment decision affects its exposure to a systematic risk factor. As a leading example, we consider a manager’s decision to invest in a “green” project based on her firm’s stock price. The price reflects both investors’ information about project cash flows and its discount rate, which depends on investors’ exposure to climate risk. The interaction between the firm’s investment decision and its usefulness as a hedge yields novel predictions about the likelihood of investment, expected returns, and future profitability. Moreover, while feedback makes the investment decision more informationally efficient, it can reduce investor welfare.

Keywords: feedback effects, welfare, investment efficiency, hedging, market completeness, risk sharing, discount rate

JEL Classification: D82, D84, G12, G14