Entrepreneurial risk aversion, net worth effects and real fluctuations

• Published date: 01 November 2013
• Author: Cristian Pardo
• Date: 01 November 2013
• DOI: http://doi.org/10.1016/j.rfe.2013.05.007

Entrepreneurial risk aversion, net worth effects and real fluctuations

Cristian Pardo ⁎

Department of Economics, Saint Joseph's University, 5600 City Avenue, Philadelphia, PA 19131, United States

abstractarticle info

Article history:

Received 4 August 2012

Received in revised form 21 May 2013

Accepted 29 May 2013

Available online 10 June 2013

JEL classification:

D82

E32

Keywords:

Entrepreneurial risk aversion

Asymmetric and private information

Contracts

Business cycles

This paper examines the combined effect of asymmetric information and private entrepreneurial risk aver-

sion on investment decisions. The standard optimal debt contract becomes modified by the introduction of

insurance and a risk premium that entrepreneurs demand due to the uncertainty of their investment returns:

the private equity premium. In general equilibrium, the private equity premium may become a mechanism

that magnifies the effects of shocks. A structural estimation of the model's parameters using Chilean and

U.S. data shows that the entrepreneurial risk aversion assumption has more empirical relevance in an econ-

omy where smaller privately-held businesses are relatively more prevalent than where the corporate sector

predominates, like the U.S.

© 2013 Elsevier Inc. All rights reserved.

1. Introduction

The fact that emerging markets tend to present stronger output

responses to shocks than industrialized economies has been widely

studied in the literature. Backus and Kehoe (1992)and Prasad, Agen or,

and McDermott (1999),tonameafew,provideempiricalevidence

supporting such an assertion. More often than not, differences in

observed average GDP volatility among countries are attributed to vari-

ations in the levels of development of their financial markets. In some

economies, however, the entrepreneurial sector can be a significant

source of volatility as well.

Table C.1, which presents the volatility of entrepreneurial activity

across countries as measured by the standard deviation of the Total

Entrepreneurial Activity index (TEA),

1

shows that the volatility of

entrepreneurial activity is on average more than 2.5 times larger in

developing countries than in developed ones. An illustrative example

is the Chilean case. While it boasts one of the most robust financial

systems in its region, its economy still reacted strongly to the effects

of the Asian crisis of the late 1990s. A reason often cited for the

observed response was that the entrepreneurial sector in Chile moved

quickly from an early-to-mid 1990's boom euphoria to a deepdepres-

sion in the followingyears.

While numerous models have attempted to explain business cycle

fluctuations as a result of financial imperfections, few incorporate the

behavior of the entrepreneurial sector as a direct mechanism behind

business cycles volatility. Fig. C.1 provides preliminary evidence of a

positive simple direct correlation between the total entrepreneurial

activity volatility and output growth volatility, as measured by the

standard deviations of the TEA index and per capita real GDP growth

for 31 countries, respectively.

This paper deals with the role of the private entrepreneurial sector

as an additional source of business cycle volatility. As in Bernanke and

Gertler (1989), capital-producing entrepreneurs finance their invest-

ments by engaging in debt contracts with lenders, a relationship that

is subject to standard frictions such as asymmetric information prob-

lems. In addition, this paper introduces a second friction in this model

that results from private entrepreneurial risk aversion.

For simplicity, entrepreneurs are commonly modeledas risk-neutral

agents. As Gale andHellwig (1985) point out that, “risk neutrality is not

an unreasonable assumption to makein the case of investorssince it can

be justified as a consequence of risk-pooling”.However,theauthorsalso

claim that risk neutrality “makes lesssense in the case of entrepreneurs

and indeed is merely a ‘simplifying’assumptionwhich shouldbe relaxed

if possible.”That is, as entrepreneurs are less likely to have access to

complete risk-pooling for their idiosyncratic risks, risk aversion is argu-

ablya more realisticassumption inmodeling theirinvestment decisions.

In fact, Moskowitz and Vissing-Jørgensen (2002) show that private

entrepreneurs tend to invest in privately-owned businesses that are typ-

icallysmall and ownedby few or just oneentrepreneur.The authors also

find that private entrepreneurs usually invest at least 50% of their assets

Review of Financial Economics 22 (2013) 158–168

⁎Tel.: +1 610 660 1526; fax: +1 610 660 3379.

E-mail address: cpardo@sju.edu.

1

This index, developed by the Global Entrepreneurship Monitor (GEM), measures

the relative amount of nascent entrepreneurs and business owners of young firms for

75 countries from 2001 to the present (van Stel, Carree, & Thurik, 2005).

1058-3300/$ –see front matter © 2013 Elsevier Inc. All rights reserved.

http://dx.doi.org/10.1016/j.rfe.2013.05.007

Contents lists available at ScienceDirect

Review of Financial Economics

journal homepage: www.elsevier.com/locate/rfe