Financial Contracting As Behavior Towards Risk: The Corporate Finance of Business Cycles

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This paper describes an equilibrium macro finance model where contracts are the mechanism by which differentially risk averse bondholders and stockholders resolve a conflict of interest problem and confront the risks associated with future operating decisions and financing decisions of a representative firm/economy. In resolving this conflict of interest problem the interrelated covenants in the financial contract shape certain stylized financial facts of business cycles ignored in Classical and Keynesian models. The model set-up includes 2 agents (bondholders and stockholders); 2 decisions (production-investment decisions generating operating income and operating risk) and (financial decisions generating financial risk); and 2 no-arbitrage equilibrium conditions (market value equals economic book value for both bonds and stocks). In this 2x2x2 set-up contract constrained managers of the representative firm make production-investment decisions that conform to the risk aversion of stockholders as reflected in stock prices, and then use financing decisions to offset any effect of a change in operating risk on the market valuation of bonds. In this model managers work for both stockholders and bondholders. Preliminary evidence from the U.S. non-financial corporate sector does not reject the predictions of the model. A similar form of risk and return sharing is shown to occur between more risk averse mature and experienced workers with seniority and less risk averse young apprentice workers.