Financial innovations, idiosyncratic risk, and the joint evolution of real and financial volatilities

J. Christina Wang

Proceedings, 2006, issue Nov

Abstract: This paper presents a model in which financial innovations explain three widely discussed stylized facts regarding trends in economic volatility over the past two decades. Aggregate volatility of real variables such as output has fallen. In particular, the covariance between firm and industry activities has declined, and so has employment volatility for the majority of firms. In contrast, the volatility of quantities of financial variables has increased at both the firm and aggregate level. The model links these outcomes to a single hypothesized cause: advances in financial technology brought about by a declining cost of information processing. As a result, the marginal cost of external funds has likely declined, reducing the need for firms to smooth cash flows. Firms, trading off cash-flow vs. production smoothing, therefore have more incentive to smooth production. This explains why financial volatility may go up as real volatility goes down. Moreover, financial innovations have likely also altered the composition of volatility toward a greater share of idiosyncratic risk, by facilitating diversification and thus lowering the premium demanded on idiosyncratic risk. At the margin, the cost advantage to projects with idiosyncratic returns reduces the covariance of financial as well as real activities across firms. Since variance and covariance of real quantities trend in the same direction, real aggregate volatility declines. But the net effect on financial variables is ambiguous and so can yield greater aggregate volatility. The paper then presents evidence that the share of idiosyncratic risk has risen in bank portfolios, indicating that the same has occurred for individual borrowers as well.

Date: 2006
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

Downloads: (external link)
https://www.frbsf.org/wp-content/uploads/7_Wang.pdf Full Text (text/html)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:fip:fedfpr:y:2006:i:nov:x:9

Ordering information: This journal article can be ordered from

Access Statistics for this article

More articles in Proceedings from Federal Reserve Bank of San Francisco Contact information at EDIRC.
Bibliographic data for series maintained by Federal Reserve Bank of San Francisco Research Library ().