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Session Overview
CFGT-4: Uncertainty and Ambiguity
Friday, 25/Aug/2017:
8:30am - 10:00am

Session Chair: David L. Dicks, Baylor University
Location: O133

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The Finance-Uncertainty Multiplier

Iván Alfaro1, Nicholas Bloom2, Xiaoji Lin1

1The Ohio State University; 2Stanford University

Discussant(s): Gill Segal (UNC Chapel Hill)

We show theoretically and empirically how real and financial frictions amplify the impact of uncertainty shocks on firms' investment, employment, debt (term structure of debt growth), and cash holding. We start by building a model with real and financial frictions, alongside uncertainty shocks, and show how adding financial frictions to the model roughly doubles the negative impact of uncertainty shocks on investment and hiring. The reason is higher uncertainty induces the standard negative real-options effects on the demand for capital and labor, but also leads firms to hoard cash and cut debt to hedge against future shocks, further reducing investment and hiring. We then test the model using a panel of US firms and a novel instrumentation strategy for uncertainty exploiting differential firm exposure to exchange rate and factor price volatility. We find that higher uncertainty reduces real investment and hiring, while also leading firms to increase cash holdings by cutting debt, dividends and stock-buy backs, and these effects are strongest in periods of higher financial frictions and for the most financially constrained firms. This highlights why in periods with greater financial frictions -- like during the global-financial-crisis -- uncertainty can be particularly damaging.

EFA2017-1352-CFGT-4-Alfaro-The Finance-Uncertainty Multiplier.pdf

Robust Security Design

Seokwoo Lee1, Uday Rajan2

1George Mason University; 2University of Michigan

Discussant(s): Alejandro Rivera (University of Texas at Dallas)

We consider the optimal contract between an entrepreneur and investors in a single-period model when both parties have limited liability, are risk-neutral toward cash flow risk, and are ambiguity-averse. Ambiguity aversion is modeled by multiplier preferences for robustness toward model uncertainty, as in Hansen and Sargent (2001). Efficient ambiguity-sharing implies that the first-best contract consists of either convertible debt or levered equity. As is customary, in the second-best contract, moral hazard is alleviated by giving more cash to investors in low cash flow states. Under many settings in our model, the optimal security has an equity-like component in high cash flow states, providing a contrast to the results in Innes (1990).

EFA2017-1930-CFGT-4-Lee-Robust Security Design.pdf

Ambiguity and the Tradeoff Theory of Capital Structure

Yehuda Izhakian1, David Yermack2, Jaime F. Zender3

1Baruch College; 2NYU Stern School of Business; 3University of Colorado Boulder

Discussant(s): Anton Tsoy (Einaudi Institute for Economics and Finance)

We examine the importance of ambiguity, or Knightian uncertainty, in the capital structure decision. We develop a static tradeoff theory model in which agents are both risk averse and ambiguity averse. The model confirms the usual idea that increased risk|the uncertainty over known possible outcomes leads firms to use less leverage. Conversely, greater ambiguity the uncertainty over the probabilities associated with the outcomes leads firms to increase leverage. Our empirical analysis provides results consistent with these predictions.

EFA2017-785-CFGT-4-Izhakian-Ambiguity and the Tradeoff Theory of Capital Structure.pdf

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