Financial Frictions, Volatility, and Skewness

A number of recent papers use the interaction of firm idiosyncratic volatility shocks with firm financial frictions to explain business cycle fluctuations. I argue that a key parameter for these models is the cost of default, as it has a quantitatively first-order effect on the magnitude of the decline in employment and other aggregates in response to idiosyncratic volatility shocks. I use firm-level panel data and a structural model of financial frictions and volatility shocks to assess the role of volatility shocks and the cost of default on firm and aggregate employment over the business cycle. I find that when the cost of default is calibrated to the range of estimates coming from the corporate finance literature, the model reproduces key cross-sectional moments of equity volatility, bond spreads, and employment growth. However, this calibration implies aggregate employment losses driven by shocks to firm idiosyncratic volatility are modest. I propose two additional shocks calibrated using firm-level panel data which could amplify the decline in employment in the context of such a model. First, the decline in employment is amplified when the increase in firm idiosyncratic risk is modeled not only as a positive second moment shock but also a negative third moment shock. Second, a plausible increase in the cost of default over the business cycle can interact with volatility shocks to dramatically reduce aggregate employment.