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NBER WORKING PAPER SERIES EQUILIBRIUM ASSET PRICES UNDER IMPERFECT CORPORATE CONTROL James Dow Gary Gorton Arvind Krishnamurthy Working Paper 9758 http://www.nber.org/papers/w9758 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 June 2003 We thank Phil Bond, Bob Chirinko, Phil Dybvig, Joe Haubrich, and Jeremy Stein for their comments. We also thank members of seminar audiences at the University of Chicago, ECB-Frankfurt, Duke University, Northwestern University, University of Rochester, Stockholm School of Economics, NBER CF meeting and the NBER Summer Institute (EFEL) for helpful comments. The views expressed herein are those of the authors and not necessarily those of the National Bureau of Economic Research. ©2003 by James Dow, Gary Gorton, and Arvind Krishnamurthy. All rights reserved. Short sections of text not to exceed two paragraphs, may be quoted without explicit permission provided that full credit including © notice, is given to the source.

NBER WORKING PAPER SERIES EQUILIBRIUM ASSET … · EQUILIBRIUM ASSET PRICES UNDER IMPERFECT CORPORATE CONTROL ... thank members of seminar ... Equilibrium Asset Prices Under Imperfect

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NBER WORKING PAPER SERIES

EQUILIBRIUM ASSET PRICES UNDER IMPERFECT CORPORATE CONTROL

James DowGary Gorton

Arvind Krishnamurthy

Working Paper 9758http://www.nber.org/papers/w9758

NATIONAL BUREAU OF ECONOMIC RESEARCH1050 Massachusetts Avenue

Cambridge, MA 02138June 2003

We thank Phil Bond, Bob Chirinko, Phil Dybvig, Joe Haubrich, and Jeremy Stein for their comments. We alsothank members of seminar audiences at the University of Chicago, ECB-Frankfurt, Duke University, NorthwesternUniversity, University of Rochester, Stockholm School of Economics, NBER CF meeting and the NBER SummerInstitute (EFEL) for helpful comments. The views expressed herein are those of the authors and not necessarilythose of the National Bureau of Economic Research.

©2003 by James Dow, Gary Gorton, and Arvind Krishnamurthy. All rights reserved. Short sections of textnot to exceed two paragraphs, may be quoted without explicit permission provided that full credit including© notice, is given to the source.

Equilibrium Asset Prices Under Imperfect Corporate ControlJames Dow, Gary Gorton, and Arvind KrishnamurthyNBER Working Paper No. 9758June 2003JEL No. G12, G30

ABSTRACT

Shareholders have imperfect ontrol over the decisions of the management of a firm. We integrate

a widely accepted version of the separation of ownership and control -- Jensen's (1986) free cash

flow theory--into a dynamic equilibrium model and study the effect of imperfect corporate control

on asset prices and investment. We assume that firms are run by empire-building managers who

prefer to invest all free cash flow rather than distributing it to shareholders. Sharefholders are aware

of this problem but it is costly for them to intervene to increase earnings payouts. Our corporate

finance approach suggests that the aggregate free cash flow of the corporate sector is an important

state variable in explaining asset prices and investment. We show that the business cycle variation

in free cash flow helps explain the cyclical behavior of interest rates and the yield curve. The

stochastic variation in free cash flow sheds light on risk premia in corporate bonds and out-of-the-

money put options. We show that the financial friction causes shocks to affect investment, and

causes otherwise i.i.d. shocks to be transmitted from period to period. Unlike the existing

macroeconomics literature on financial frictions, the shocks propagate through large firms and

during booms.

James Dow Gary Gorton Arvind KrishnamurthyLondon Business School Department of Finance Department of FinanceSussex Place The Wharton School Northwestern University Regents Park University of Pennsylvania Kellogg School of BusinessLondon NW1 4SA Philadelphia, PA 19104-6367 2001 Sheridan RoadUnited Kingdom and NBER Evanston, IL [email protected] [email protected] [email protected]

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