The permanent-income hypothesis (PIH) of Milton Friedman (1957) states that the agent saves in anticipation of possible future declines in labor income (John Y. Campbell, 1987). He also saves for precautionary reasons, and dissaves because of impatience. To justify the PIH in an intertemporal optimization framework, it has been conventional to assume both (i) quadratic utility, to turn off precautionary motives (Robert E. Hall, 1978), and (ii) equality between the subjective discount rate and the interest rate, in order to rule out dissavings for lack of patience. Neither assumption is plausible. Much work on consumption in the past decade has focused on individual’s precautionary savings motives and liquidity constraints. Impatience is a standard result in heterogeneousagents general-equilibrium incomplete-markets models, generally known as Bewley models. This paper shows that the PIH is in any case the optimal rule, in a Bewley model, in which each agent solves the precautionary-savings model of Caballero (1990, 1991). In addition to the demand for savings for a “rainy day,” Caballero’s model also predicts a constant precautionary-savings demand and constant dissavings due to impatience. In equilibrium, I show that these two forces must cancel each other. As a result, the agent behaves in accordance with the PIH. Section I describes the model. Section II concludes. The Appendix provides a heuristic derivation and a proof of the optimal consumption rule.

Entrepreneurs often face undiversifiable idiosyncratic risks from their business investments. We extend the standard real options approach to an incomplete markets environment and analyze the joint decisions of business investments, consumption/savings, and portfolio selection. For a lump-sum investment payoff and an agent with a sufficiently strong precautionary savings motive, an increase in volatility can accelerate investment, contrary to the standard real options analysis. When the agent can trade the market portfolio to partially hedge against investment risk, the systematic volatility is compensated via the standard CAPM argument, and the idiosyncratic volatility generates a private equity premium. Finally, when the investment payoff is a series of flows, the agent's idiosyncratic risk exposure alters both the implied option value and the implied project value, causing a reversal of the results in the lump-sum payoff case.

Heterogeneity is ubiquitous in firm-level and sectoral data. Equilibrium models, how-ever, typically assume a representative firm, as in Andrew B. Abel and Olivier J. Blanchard (1983). The representative firm paradigm leaves no role for the distribution of capital. We model capital reallocation in a general equilibrium model with two sectors. Capital adjustment costs capture illiquidity in our model, similar to Hirofumi Uzawa’s (1969) capital installation technology. We follow Fumio Hayashi (1982) in assuming that the production technology is linearly homogeneous, which allows us to focus on the sectoral distribution of capital, separately from the level of total capital. The two sectors may have different levels of productivity, and we show that the distribution of capital between the two sectors is the single state variable gov-erning investment, growth, and valuation in the economy.We analytically characterize prices and quan-tities, including investment, growth, the interest rate, and the price of capital (Tobin’s

We develop a dynamic contingent-claim framework to model S. Myers’s idea that a firm is a collection of growth options and assets in place. The firm’s composition between assets in place and growth options evolves endogenously with its investment opportunity set and its financing of growth options, as well as its dynamic leverage and default decisions. The firm trades off tax benefits with the potential financial distress and endogenous debt-overhang costs over its life cycle. Unlike the standard capital structure models of Leland, our model shows that financing and anticipated endogenous default decisions have significant implications of firms’ growth-option exercising decisions and leverage policies. The firm’s ability to use risky debt to borrow against its assets in place and growth options substantially influences its investment strategies and its value. Quantitatively, we find that the firm consistently chooses conservative leverage in line with empirical evidence in order to mitigate the debt-overhang effect on the exercising decisions for future growth options. Finally, we find that debt seniority and debt priority structures have both conceptually important and quantitatively significant implications on growth-option exercising and leverage decisions as different debt structures have very different debt-overhang implications.

ABSTRACT An investor receives utility bursts from realizing gains and losses at the individual stock level and dynamically allocates his mental budget between risky and risk‐free assets at the trading account level. Using savings, he reduces his stockholdings and is more willing to realize losses. Using leverage, he increases his stockholdings beyond his mental budget and is more reluctant to realize losses. While leverage strengthens the disposition effect, introducing leverage constraints mitigates it. Our model predicts that investors with stocks in deep losses sell them either immediately or after stocks rebound a little.

Hedge fund managers trade off the benefits of leveraging on the alpha-generating strategy against the costs of inefficient fund liquidation. In contrast to the standard risk-seeking intuition, even with a constant-return-to-scale alpha-generating strategy, a risk-neutral manager becomes endogenously risk-averse and decreases leverage following poor performance to increase the fund's survival likelihood. Our calibration suggests that management fees are the majority of the total compensation. Money flows, managerial restart options, and management ownership increase the importance of high-water-mark-based incentive fees but management fees remain the majority. Investors' valuation of fees are highly sensitive to their assessments of the manager's skill.

We investigate whether the performance of private equity (PE) investments is sufficient to compensate investors (LPs) for risk, long-term illiquidity, management, and incentive fees charged by the general partner (GP).We analyze the LPs’ portfolio-choice problem and find that management fees, carried interest, and illiquidity are costly, and GPs must generate substantial alpha to compensate LPs for bearing these costs. Debt is cheap and reduces these costs, potentially explaining the high leverage of buyout transactions. Conventional interpretations of PE performance measures appear optimistic. On average, LPs may just break even, net of management fees, carry, risk, and costs of illiquidity.

The presence of a well designed bankruptcy code is an important part of the financial architecture in developed economies. By allowing the creditors to seize the assets of the borrowers who fail to make contractual payments, the code generates beneficial ex ante effects on debt capacity and firm value. By giving the borrowers options to renegotiate their debt obligations and seek bankruptcy protection, the code increases the likelihood that borrowers may avoid inefficient ex post liquidation. As Hart (1999) notes, the code should balance ex ante firm value maximization with ex post efficiency. The bankruptcy codes in different countries weight this tradeoff differently and hence vary in terms of the distribution of rights and powers between borrowers and lenders. In this paper, we provide an inter-temporal framework to examine how the creditors’ liquidation rights and the distribution of ex post bargaining powers influence the firm’s investment and financing decisions, and affect ex ante firm value. We show that stronger equityholders ’ bargaining power lowers debt capacity, reduces firm value, and discourages growth option exercising. Our calibration suggests that the quantitative effects of ex post strategic renegotiation on ex ante firm value may be large.

We develop an incomplete-markets q-theoretic model to study entrepreneurship dynamics. Precautionary motive, borrowing constraints, and capital illiquidity lead to underinvestment, conservative debt use, under-consumption, and less risky portfolio allocation. The endogenous liquid wealth-illiquid capital ratio w measures time-varying financial constraint. The option to accumulate wealth before entry is critical for entrepreneurship. Flexible exit option is important for risk management purposes. Investment increases and the private marginal value of liquidity decreases as w decreases and exit becomes more likely, contrary to predictions of standard financial constraint models. We show that the idiosyncratic risk premium is quantitatively significant, especially for low w.

We model the welfare consequences of mandates that restrict investors to hold firms with net-zero carbon emissions. To qualify for these mandates, value-maximizing firms have to accumulate decarbonization capital. Qualification lowers a firm’s required return by its decarbonization investments divided by Tobin’s q, that is, the greenium or the dividend yield shareholders forgo to address the global-warming externality. The welfare-maximizing mandate approximates the first-best solution, yielding welfare gains compared to laissez-faire by mitigating the weather disaster risks resulting from carbon emissions. Our model generates optimal transition paths for decarbonization that we use to evaluate proposed net-zero targets. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online