Entrepreneurial Finance and Nondiversifiable Risk

Hui Chen; Jianjun Miao; Neng Wang

doi:10.1093/rfs/hhq122

Entrepreneurial Finance and Nondiversifiable Risk

Hui Chen¹; Jianjun Miao^2,3; Neng Wang⁴

¹ MIT Sloan School of Management and NBER · ² Central University of Finance and Economics · ³ Zhongnan University of Economics and Law · ⁴ Shanghai University of Finance and Economics

Review of Financial Studies 2010 open access

We develop a dynamic incomplete-markets model of entrepreneurial firms, and demonstrate the implications of nondiversifiable risks for entrepreneurs' interdependent consumption, portfolio allocation, financing, investment, and business exit decisions. We characterize the optimal capital structure via a generalized tradeoff model where risky debt provides significant diversification benefits. Nondiversifiable risks have several important implications: More risk-averse entrepreneurs default earlier, but choose higher leverage; lack of diversification causes entrepreneurial firms to underinvest relative to public firms, and risky debt partially alleviates this problem; and entrepreneurial risk aversion can overturn the risk-shifting incentives induced by risky debt. We also analytically characterize the idiosyncratic risk premium.

DOI: 10.1093/rfs/hhq122
Volume: 23 (12)
Pages: 4348-4388
Language: en
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