Financial Contracting As Behavior Towards Risk : The Corporate Finance of Business Cycles

In this paper I develop a model that focuses attention on the financial side of business cycles. Investors in this model separate into bondholders and stockholders based on differences in risk aversion that creates a conflict of interest problem for the future management of the representative firm. This conflict of interest problem is resolved with an optimal bond contract with multiple linked covenants that shape certain stylized financial facts of business cycles not considered in Classical and Keynesian models. The model set-up includes 2 agents (bondholders and stockholders); 2 decisions (investment decisions generating operating income and risk, and financing decisions generating financial risk); and 2 no-arbitrage conditions where market valuations for both bonds and stocks equals their respective current cost book valuations. In this 2x2x2 set-up it is optimal for the contract constrained manager to make investment decisions that conform to the risk aversion of stockholders as reflected in stock prices. The contract then required that a financing decision be made that offsets effects of a change in operating risk on the market valuations of bonds. In this contract guided economy market valuations of bonds and stocks interact with investment decisions and financing decisions to produce business cycles where no investor is exploited. Preliminary evidence on the cyclical pattern of investment and financing decisions fails to reject the predictions of the model. I touch upon but leave for future research other two twofold classifications in the study of business cycles such as the cyclical movement of small young risky firms versus large mature and relatively less risky firms; and young less risk averse apprentice workers versus mature but more risk averse experienced workers