Financial Innovations
and Macroeconomic Volatility
Urban Jermann & Vincenzo Quadrini
Discussion 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




p' ( y ' k ' b' )
V ( s, k , b)  max  e   



k ',b ',e
 (1  p' )( y ' k ' b')
b'
a
s.t. e  e   ( yk  b)  k '
R




p' ( y ' k ' b' )
b'   



 (1  p' )( y ' k ' b')
2
A simplified version



V ( s, k , b)  max  e   y ' k ' b'(1  p' )
k ',b ',e
b'
a
s.t. e  e   yk  b  k '
R


b'   y ' k ' b'(1  p' )
2



First-Order Conditions
e : 1   (1  e)

 1
k ':   y ' k '
b':  (1  )   
(1  )

R
p does not show up directly but comes in through 
Frictionless solution
if  = 0 &  = R-1
e : 1   (1  e)
b':  (1  )   
Equity can “undo” the friction on debt financing

R
First-Order Conditions
1

 1
 y ' k ' (1  )
(1  e)
p'     
if k '  (and y '  0)
then e , i.e., net equity issuance is counter - cyclical
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 countercyclical
Levy and Hennessy (pro-cyclical):
• Obtaining equity becomes easier during
boom
Theory on cyclical behavior of equity
Choe, 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 TFP
Cyclical equity issuance costs
Cyclical required rate of return on risky assets
Alternative bargaining
First-Order Conditions
1

 1

y ' k ' (1  )
1  e
1

 1
  ( p' ) ( p' ) p'y ' k ' (1  )
1   ( p ' )e
p'    ,  ( p' ) ,  ( p' ) , p' ,  ( p' ) 
Thus equity could very well increase
Would modifications matter
for 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 Results
Jerman 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 marketbased leverage ratio has been about 0.32. There
have been surprisingly small fluctuations in this
ratio from decade to decade.
Some of the Empirical Results
Jerman 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