Financial Innovations and Macroeconomic Volatility

Urban Jermann & Vincenzo QuadriniDiscussion by Wouter J. Denhaan

Excellent new framework

• Both debt and equity as external finance (typically only one form of external finance)

• Aggregate shock is a change in the probability of “market loss”, which is like a change in ownership.

• No aggregate or idiosyncratic TFP shocks

Excellent topic• Study cyclical properties of debt and equity• Study impact of financial innovation on

volatility of debt, equity, & output

Nice set of results• Financial innovation can explain changes in

volatility• Innovations in equity markets seem more

important for reduction in volatility than innovations in debt markets

• Output much more volatile than measured TFP

Link between theory and empirical result

• Paper tries to do too much, i.e., tries to match too many empirical results

• For some results, neither the empirical estimates nor the theoretical predictions are very robust to modifications

• Better to focus on key predictions of the paper

Outline

• Simplified version of model• Cyclical behavior of debt and equity • Modifications of the model• Empirical findings

A simplified version

)''')('1()'''('

'

')('..

)''')('1()'''('

),,(

2

,','max

bkypbkyp

b

kbykRbeets

bkypbkyp

ebksV

a

ebk

A simplified version

)'1(''''

''..

)'1('''),,(

2

,','max

pbkyb

kbykRbeets

pbkyebksV

a

ebk

First-Order Conditions

Rb

kyk

ee

)1(:'

)1('':'

)1(1:1

p does not show up directly but comes in through

Frictionless solution if = 0 & = R-1

Rb

ee

)1(:'

)1(1:

Equity can “undo” the friction on debt financing

First-Order Conditions

cyclical-counter is issuanceequity net i.e., ,then

)0' (and ' if

'

)1('')1(

1 1

e

yk

p

kye

Theory on cyclical behavior of debt and equity

Substitutes• Jermann and Quadrini (2006)

– Debt pro-cyclical and equity countercyclical• Levy and Hennessy (2006)

– opposite

Complements• Covas and Denhaan (2006)

– Debt and equity pro-cyclical

Theory on cyclical behavior of equity

Jerman and Quadrini (counter-cyclical):• No increase in need of funds during boom,

but obtaining debt financing becomes easier• Debt procyclical and equity countercyclicalLevy and Hennessy (pro-cyclical):• Obtaining equity becomes easier during

boom

Theory on cyclical behavior of equityChoe, Masulis, and Nanda (pro-cyclical)• Adverse selection problem is relatively less

important during a boom• Equity issuance implies a transfer to debt holdings

(reduction in default probability and the value of this transfer is smaller during a boom)

• Covas and Denhaan (pro-cylical)• Standard debt contract with default Desire to

expand leads to tightening of bank break-even condition pro-cyclical equity issuance

• Counter-cyclical risk premium and equity issuance costs

How would alternatives affect cyclical behavior of equity

What if lending rate increases with debt?• First-order condition for equity and capital not

affected• With standard debt contract & default & bankruptcy

costs, however, equity issuance would be procylcical

Cyclical exogeonous TFPCyclical equity issuance costsCyclical required rate of return on risky assets Alternative bargaining

First-Order Conditions

increase very wellcouldequity Thus

)'(,',)'(,)'(,'

)1(''')'()'()'(1

1

)1(''1

1

1

1

ppppp

kypppep

kye

Would modifications matterfor main prediction of model?

• Some might but several will not affect the result that easing of financial constraints reduces output volatility and increases debt and equity volatility

Some of the Empirical ResultsJerman and Quadrini Empirical Fact #2“The debt exposure [debt/gdp] has increased during

the last 50 years”Frank and Goyal Stylized Fact #1“Over long periods of time, leverage [debt/assets] is

stationary”Frank and Goyal Stylized Fact #2“Over the past half century, the aggregate market-

based leverage ratio has been about 0.32. There have been surprisingly small fluctuations in this ratio from decade to decade.

Some of the Empirical ResultsJerman and Quadrini Empirical Fact #3“Equity payouts [dividends minus equity issuance

scaled by GDP] are counter-cyclical”Covas and Denhaan• Dividends are pro-cyclical across firms• Aggregate results affected by largest top 1 to 5%

and by leveraged buyouts• If you take out mergers

– (Net) Equity issuance is pro-cyclical for most firms– (Net) Equity issuance counter-cyclical for top 1%– No clear pattern with aggregate data

Minor Comments

• Is it costly to issue dividends/repurchase shares? As costly as issuing new equity

• Model is a bit of a black box• Does the representative firm ever issue equity?• How important are changes in asset prices?

Concluding comments

• Optimal contracts: – One type of contract– No unique way of implementing it with cash reserves,

debt, & equity– Often odd properties like no defaults

• Fixed types of contracts:– Frictions too segmented. For example, couldn’t you

avoid friction on debt finance by also buying some equity?

– More helpful in understanding data