Feedback Effects and Systematic Risk Exposures

Abstract

We model the "feedback effect" of a firm's stock price on investment in projects exposed to a systematic risk factor, like climate risk. The stock price reflects information about both the project's cash flows and its discount rate. A cash-flow maximizing manager treats discount rate fluctuations as "noise," but a price maximizing manager interprets such variation as information about the project's NPV. This difference qualitatively changes how investment behavior depends on the project's risk exposure. Moreover, traditional objectives (e.g., cash-flow or price maximization) need not maximize welfare because they do not correctly account for hedging and risk-sharing benefits of investment.

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

JEL Classification: D82, D84, G12, G14