High-powered incentives may induce higher managerial effort, but they also expose managers to idiosyncratic risk. If managers are risk averse, they might underinvest when firm-specific uncertainty increases, leading to suboptimal investment decisions from the perspective of well-diversified shareholders. We empirically document that, when idiosyncratic risk rises, firm investment falls, and more so when managers own a larger fraction of the firm. This negative effect of managerial risk aversion on investment is mitigated if executives are compensated with options rather than with shares or if institutional investors form a large part of the shareholder base.

I explore the implications for asset prices and macroeconomic dynamics of shocks that improve real investment opportunities and thus affect the representative household's marginal utility. These investment shocks generate differences in risk premia due to their heterogeneous impact on firms: they benefit firms producing investment relative to firms producing consumption goods, and increase the value of growth opportunities relative to the value of existing assets. Using data on asset returns, I find that a positive investment shock leads to high marginal utility states. A general equilibrium model with investment shocks matches key features of macroeconomic quantities and asset prices.

Organization capital is a production factor that is embodied in the firm's key talent and has an efficiency that is firm specific. As a result, both shareholders and management have a claim on the cash flows accruing from organization capital. Because the division of rents between shareholders and key talent can systematically vary over time, shareholders investing in organization capital are exposed to additional risks. In our model, key talent can transfer a fraction of the firm's organization capital to a new enterprise, and the benefits of this reallocation vary systematically. This outside option determines the division of cash flows from organization capital between shareholders and key talent, and renders firms with high organization capital riskier. We construct a measure of organization capital based on readily available accounting data and find that firms with more organization capital relative to their industry peers outperform firms with less organization capital by 4.7% per year. This dispersion in risk premia is not explained by the CAPM, the Fama and French (1993) or Carhart (1997) models. Our model offers additional testable implications that are supported by the data.

We investigate how the inability to continuously trade an asset affects portfolio choice. We extend the standard Merton model to include an illiquid asset that can only be traded at infrequent, stochastic intervals. Because consumption is financed through liquid wealth only, the presence of illiquidity leads to increased and state-dependent risk aversion. Illiquidity leads to under-investment in both the liquid and illiquid risky asset, relative to the standard Merton (1969) case. We demonstrate that the effect of illiquidity can be quantitatively large, because in contrast to transaction costs models, the shadow cost of illiquidity is unbounded. The presence of liquidity risk distorts the allocation of the liquid and illiquid assets even when liquid and illiquid asset returns are uncorrelated and the investor has log utility.

We explore the impact of investment-specific technology (IST) shocks on the crosssection of stock returns and firms' investment using a production-based asset pricing model. The key property of our model is that the present value of growth opportunities has higher beta with respect to IST shocks than the value of assets in place, which leads to three main implications. First, firms with a higher fraction of growth opportunities in the firm value (high-growth firms) exhibit risk premia different from those of firms with fewer growth opportunities (low-growth firms). Second, high-growth firms co-move with each other, giving rise to a systematic factor in stock returns distinct from the market portfolio and related to the value factor. Third, stock return betas with respect to the IST shocks reveal cross-sectional heterogeneity in firms' growth opportunities. We find empirical support for qualitative predictions of the model. We calibrate our model and show that its main predictions for investment dynamics, cash flows and expected  returns are quantitatively consistent with the data.