Feedback Effects with Risk Aversion: An Application to Climate Risk

68 Pages Posted: 20 Apr 2021 Last revised: 1 Jun 2022

See all articles by Snehal Banerjee

Snehal Banerjee

University of California, San Diego (UCSD) - Rady School of Management

Bradyn M. Breon-Drish

University of California, San Diego (UCSD) - Rady School of Management

Kevin Smith

Stanford University Graduate School of Business

Date Written: June 28, 2021

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

Suggested Citation

Banerjee, Snehal and Breon-Drish, Bradyn M. and Smith, Kevin, Feedback Effects with Risk Aversion: An Application to Climate Risk (June 28, 2021). Available at SSRN: https://ssrn.com/abstract=3825025 or http://dx.doi.org/10.2139/ssrn.3825025

Snehal Banerjee (Contact Author)

University of California, San Diego (UCSD) - Rady School of Management ( email )

9500 Gilman Drive
Rady School of Management
La Jolla, CA 92093
United States

Bradyn M. Breon-Drish

University of California, San Diego (UCSD) - Rady School of Management ( email )

9500 Gilman Drive
Rady School of Management
La Jolla, CA 92093
United States

Kevin Smith

Stanford University Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States

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