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Under-diversification and idiosyncratic risk externalities

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  • Iachan, Felipe S.
  • Silva, Dejanir
  • Zi, Chao

Abstract

We study the effects of idiosyncratic uncertainty on asset prices, investment, and welfare. We consider an economy with two main components: under-diversification and endogenous, countercyclical idiosyncratic risk. The equilibrium is subject to underinvestment and excessive aggregate risk-taking. Inefficiencies stem from an idiosyncratic risk externality, as firms do not internalize the effect of their investment decisions on the risk borne by others. Risk externalities depend on an idiosyncratic risk premium and a variance risk premium. We assess their magnitude empirically. The optimal allocation can be implemented through financial regulation using a tax benefit on debt and risk-weighted capital requirements.

Suggested Citation

  • Iachan, Felipe S. & Silva, Dejanir & Zi, Chao, 2022. "Under-diversification and idiosyncratic risk externalities," Journal of Financial Economics, Elsevier, vol. 143(3), pages 1227-1250.
    • Handle: RePEc:eee:jfinec:v:143:y:2022:i:3:p:1227-1250
    DOI: 10.1016/j.jfineco.2021.05.001
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    More about this item

    Keywords

    Idiosyncratic risk; Under-diversification; Risk-taking; Pecuniary externalities;
    All these keywords.

    JEL classification:

    • E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Investment; Capital; Intangible Capital; Capacity
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation

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