DP11950 Uncertainty shocks, asset supply and pricing over the business cycle

Author(s): Francesco Bianchi, Cosmin Ilut, Martin Schneider
Publication Date: April 2017
Keyword(s): Asset Pricing, Business cycle, DSGE, Markov-switching
JEL(s): C32, E32, G12
Programme Areas: Financial Economics, Monetary Economics and Fluctuations
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=11950

This paper estimates a business cycle model with endogenous financial asset supply and ambiguity averse investors. Firms' shareholders choose not only production and investment, but also capital structure and payout policy subject to financial frictions. An increase in uncertainty about profits lowers stock prices and leads firms to substitute away from debt as well as reduce shareholder payout. This mechanism parsimoniously accounts for postwar comovement in investment, stock prices, leverage and payout, at both business cycle and medium term cycle frequencies. Ambiguity aversion permits a Markov-Switching VAR representation of the model, while preserving the effect of uncertainty shocks on the time variation in the equity premium.