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Risk-Taking Executives, The Value of the Firm and Economic Performance

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  • Francisco Covas

Abstract

This paper develops a new framework that combines agency problems associated with managerial behavior and firm finance in a dynamic macroeconomic model. Agency costs arise because neither the shareholders nor the debt provider can directly control the manager's choice of how much risk to assume, and in particular, the manager generally risks more than the shareholders would deem appropriate. At the firm level, it is shown the risk-taking friction worsens as the bargaining power of the manager with the shareholders increases, and some empirical evidence consistent with this prediction is presented. At the macro level, risk taking declines when aggregate productivity is high. In addition, a positive aggregate shock increases the value of the firm and thus alleviates the agency problem with the debt provider. As such, the reduction in borrowing costs and risk further increase the firm's earnings potential and enhances the model's ability to amplify the effect of shocks. Because the manager obtains some of the increase in profits and, at some point, owners will take out funds of the firm, there are important ``leakage'' effects that limit the role of net worth as a propagation mechanism. Still, the increase in asset prices induces firms to go public, and because these do not disappear quickly, this is a powerful mechanism for the propagation of shocks

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2004 Meeting Papers with number 80.

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Date of creation: 2004
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Handle: RePEc:red:sed004:80

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Keywords: Convex contracts; Risk-taking incentives; Magnification of shocks;

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Cited by:
  1. Francisco Covas & Wouter J. den Haan, 2006. "The Role of Debt and Equity Finance over the Business Cycle," Working Papers 06-45, Bank of Canada.
  2. João Ejarque, 2004. "Neoclassical Investment with Moral Hazard," Working Papers w200417, Banco de Portugal, Economics and Research Department.

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