Abstract
This paper studies the effects of changes in uncertainty on optimal leverage and investment in a dynamic firm-financing model in which firms have access to complete markets subject to collateral constraints. Entrepreneurs finance projects with their net worth and by issuing state-contingent securities, which have to be collateralized with physical capital. An increase in uncertainty leads to deleveraging, as entrepreneurs reduce their demand for external financing to be able to hedge the larger shocks. Initially deleveraging leads to a drop in investment. Investment recovers as entrepreneurs build up net worth and transition into an environment with high uncertainty. Changes in uncertainty have large quantitative effects on optimal leverage and investment dynamics. Financial innovation amplifies the effects of uncertainty shocks.
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