© Nathan Mandell
Professors Robert Korajczyk, an asset pricing expert,
and Janice Eberly, an expert in real options theory.
and the business cycle
The incentives of managers to reveal bad news early is not
the only aspect of financial decision making affected by aggregate
economic conditions. Attitudes toward risk are also affected,
and this is reflected in the entrepreneurs' decisions to invest
at different times in the business cycle.
entrepreneurs are more or less risk averse depends on how
the overall economy is doing. When the economy is doing poorly,
entrepreneurs are less well off and hence more risk averse
than when the economy is doing well.
their motivation depends on how diversified their entire portfolio
of assets is.
turns out, most entrepreneurial risk is not diversified away—seemingly
surprising, given that everyone involved in entrepreneurial
pursuits tends to understand that these ventures are inherently
risky and that the risk is in large part idiosyncratic.
lenders know it, the investors know it, the entrepreneurs
know it. Why don't people then diversify the risk?" asks Rampini.
involves the motivation and incentives surrounding entrepreneurship.
have perfectly diversified the risk of your new venture, the
odds are that you won't succeed," explains Rampini. "Because
by insuring your venture, there is no upside for you anymore,
so there's no need to work as hard. The steep incentives are
similar to the dynamics that discourage capital reallocation
during recessions, when capital could typically be redeployed
quite productively, entrepreneurship tends to drop precipitously
during economic busts and rise during good times.
boom times, says Rampini, everyone is generally better off
which tends to make people less risk averse and more inclined
to launch entrepreneurial activities. If the projects do poorly,
the entrepreneurs won't likely suffer as much, because the
aggregate market is relatively forgiving when overall productivity
is up and capital relatively inexpensive.
times are tough and capital tight, however, risk aversion
good times, entrepreneurs are happier to hold risk and start
ventures," Rampini notes. "Moreover, they may also be more
able to sell risky claims on their ventures. Thus, the amount
of idiosyncratic risk that you can diversify varies over the
means that holding on to a smaller stake in the firm during
good times still provides sufficient incentives. In bad times,
though, the situation is reversed and managers have to hold
a larger fraction of the project's risk— which is a
disincentive to entrepreneurial activity.
and risk aversion move together, making booms that much better
since both aspects make it more attractive to start entrepreneurial
activities," says Rampini.
a very uncertain environment, the real options strategy
can have a significant negative impact on overall investment,
notes Prof. Janice Eberly.
of thinking about entrepreneurial activity and the associated
incentives and risk is applicable to dynamics within a firm
too, suggests Rampini. Though his research has not explicitly
considered this context, he says that there appears to be
analogous incentives inside firms that launch new divisions.
Starting a new division is clearly associated with considerable
steep must the incentives be so that the manager of a new
division will work hard?" asks Rampini. "How much of the new
division's risk must we leave with the divisional management,
and how much can we transfer to headquarters, which may care
less about the idiosyncratic risk and hence may be more willing
and able to absorb that risk?"
all the risk should go to headquarters. It doesn't, of course,
precisely because of the incentives necessary to motivate
the divisional management team. The question for the firm's
finance experts is how much risk must reside with the division
compared to headquarters.
is a simplification, admits Rampini, but it does work to illustrate
how the internal capital market may be understood as somewhat
similar to the larger capital markets in terms of risk and
options and capital assets: adding complexity
Behind all investment decisions, including the ones Rampini
and Eisfeldt have considered, rests the literature of asset
pricing and, more recently, real options. For more than two
decades, CAPM has become well defined around the core assumption
that markets prohibit the chance for investors to make large-scale
pricing models examine what kinds of risks are important,"
explains Korajczyk, adding that a central consideration for
the model involves a portfolio selection that is efficient—generating
high expected return and low standard deviation. He says that
the intuition for a lot of people is that high individual
asset volatility must correlate with a high risk premium—something
that is not true, given the insights of portfolio theory which
say that assets cannot be viewed in isolation from one another.
think about the world in a portfolio context, something with
a high volatility could increase the risk of the portfolio
or actually decrease the risk of the portfolio, depending
upon how it is correlated with the other assets in the overall
portfolio," says Korajczyk.
next step in the asset pricing literature, given this insight,
is to determine what sort of risk is going to command a risk
premium," he explains. "It's going to be risks correlated
with the assets we hold in a diversified portfolio—the
risk that is undiversifiable."
sensitivity to the overall marketplace is defined as its beta.
According to CAPM, if the aggregate investment community holds
the entire market portfolio, and if beta indicates each stock's
contribution to the portfolio risk, then investors will require
that the risk premium be aligned with beta.
notes that the more recent asset pricing literature seeks
to gain more subtle insights into risk and risk premiums.
For instance, newer capital asset pricing models try to take
into account how investors think about transaction costs and
of risk are also being explored in the real options literature,
an area that Kellogg School Professor Janice
Eberly knows well.
effort to develop a more refined framework to analyze investment,
Eberly has turned to real options, an area of financial thinking
that treats assets in a more sophisticated way, comparing
them to options that may or may not be exercised along a temporal
continuum. Options, in financial terms, are defined as having
a choice to invest in the future using terms that are fixed
in the present.
investment decisions act like options, in that you not only
have the choice to exercise them, but you can also choose
when to exercise them," says Eberly. The valuation is done
exactly like an option, she notes, so idiosyncratic risk is
intuitive part of this is that in an environment with a lot
of uncertainty, that option to delay and wait to see what
happens becomes more valuable," she explains.
result, firms often delay projects until some of the uncertainty
is resolved. Consequently, notes Eberly, in a very uncertain
environment, the real options strategy can have a significant
negative impact on overall investment, because companies are
options approach to capital investing tries to generalize
a narrow assumption associated with calculating net present
value. Textbooks assume that investments are "take it or leave
it" propositions that must be undertaken now or never. In
reality, Eberly says, things are not so straightforward.
frequently has a number of investment opportunities, she says,
including growth options that influence the company's value
in complex ways depending on whether and when the options
and her colleague Andrew B. Abel from the Wharton School have
developed a model in which a firm's opportunity to upgrade
its technology results in growth options in the value of the
value is the sum of value generated by its current technology
plus the value of the option to upgrade," they write in their
paper "Investment, Valuation, and Growth Options."
reveal that "variation in the technological frontier leads
to variation in firm value that is unrelated to current cash
flow and investment, though variation in firm value anticipates
future upgrades and investment."
real options attempts to do, Eberly says, is provide a more
dynamic way of thinking about investment decisions, refining
the textbook models in light of real-world practices.
Korajczyk points out that developments in the microstructure
literature over the last two decades have also tried to assess
investment more realistically, in part by taking a closer
look at trading costs.
are more than simply transactions associated with brokerage
commissions," says Korajczyk. "That's really just part of
the costs. There's also a bid-ask spread that you pay." And
with larger, institutional trades, he says, not only must
you pay the bid-ask spread, but you are likely to move the
price adversely against you.
the microstructure literature does is think about how we're
going to influence price when we start trading, and how we
measure these kinds of effects," says Korajczyk.
finance tools continue to evolve in ways that seek to account
for the real financial world in increasingly accurate ways.
As they do so, their complexity increases too, until they
can seem esoteric.
still remembers what initially attracted her to finance: a
desire to make the world a better place. Though she doesn't
use the word "utopian" to describe her underlying scholarly
motivations, the term seems to fit.
really interested in learning how we can get the most out
of the resources we have," she says. "The issues most compelling
to me include how we design securities so that financing goes
to the right places; how we minimize information asymmetry
to get capital into the optimal hands. The advances we have
made in finance are making it less costly to get resources
to the right places.
these questions has great implications for how happy everyone
an attitude you can take to the bank.