Entrepreneurial Risk Aversion, Net Worth Effects and Real Fluctuations

This paper examines the combined effect of asymmetric information and private entrepreneurial risk aversion on investment decisions. The standard optimal debt contract becomes modified by the introduction of insurance and a risk premium that entrepreneurs demand due to the uncertainty of their investment returns: the private equity premium. In general equilibrium, the private equity premium may become a mechanism that magnifies the effects of shocks. A structural estimation of the model’s parameters using Chilean and U.S. data shows that the entrepreneurial risk aversion assumption has more empirical relevance in an economy where smaller privately-held businesses are relatively more prevalent than where the corporate sector predominates, like the U.S.