The Impact of Uncertainty on Real and Financial Activities Iván Alfaro (OSU) Nicholas Bloom (Stanford) Xiaoji Lin (OSU) AEA January 5 th, Very Preliminary 1

Long literature arguing that uncertainty reduces real outcomes like investment and hiring….

…but what about uncertainty impacting financial decisions on debt, equity and cash behavior?

Real Financial

What this paper does: Empirical Compustat panel on investment, employment, debt, equity and cash flow, + realized & implied volatility (uncertainty) Instruments uncertainty using firm exposures to: (A) currencies, (B) oil and (C) policy uncertainty Theoretical Build a firm model with real and financial adjustment costs Simulate impact of uncertainty shocks on firm activities 5

What this paper finds: Real: uncertainty reduces investment and hiring Financial: uncertainty a)cuts debt (especially short-term, so ↑ maturity) b)cuts equity payout (dividends & stock-buybacks) c)increases cash holdings Model finds financial constraints amplify real adjustment costs, increasing real impact of uncertainty 6

1) Empirical Results 2) Model 3) Model results 7

Data Standard Compustat annual data for investment, employment and financial metrics Uncertainty proxied by realized volatility (of daily stock returns) and implied volatility (365 day ahead from Option Metrics) Apply all the usual cleaning (e.g. drop FIRE and utilities, firms with negative real values, firms with only 1 year of data etc).

How to deal with endogenous uncertainty Instrument firm by year uncertainty by the firm’s exposure to: (I)Currencies (each of the G20) (II)Oil (proxying for all energy prices) (III)Policy uncertainty Exposure for (1) & (2) measured from an initial regression at SIC 3-digit industry level of firm daily returns on currencies & oil Exposure for (3) from SIC 3-digit share of government contracts (from Baker, Bloom and Davis, 2015).

Empirical findings: Investment (1)(2)(3)(4)(5) OLS IVOLSIV RealizedImpliedRealized Uncertainty (volatility)-0.020***-0.010**-0.019***-0.012***-0.012** (-9.646)(-2.392)(-3.974)(-5.912)(-2.386) Tobin’s Q-0.014**0.023** (-2.022)(2.008) Book to Debt Ratio-0.005**0.006** (-2.448)(2.004) Stock Returns0.040***0.006 (14.537)(1.599) Log(Sales)0.387***0.411*** (16.018)(5.795) Return on Assets (0.772)(0.987) Tangibility-0.035***-0.037*** (-4.900)(-2.920) F-test of 1 st stage Observations147,54926,30710,519126,6458,703 Notes: Firm and year FEs included. All explanatory variables lagged one year. Standard errors clustered by firm. Annual data from , except Implied Volatility (col 2) for

Empirical findings: Employment (1)(2)(3)(4)(5) OLS IVOLSIV RealizedImpliedRealized Uncertainty (volatility)-0.022***-0.039***-0.035**-0.012** (-4.685)(-5.209)(-2.510)(-2.358)(-0.540) Tobin’s Q *** (0.599)(5.448) Book to Debt Ratio-0.010*** (-2.968)(-0.778) Stock Returns0.054*** (8.257)(-0.802) Log(Sales)0.338***-0.248** (9.039)(-2.170) Return on Assets (-0.452)(-1.369) Tangibility-0.027***-0.052** (-2.800)(-2.302) F-test of 1 st stage Observations147,48526,33710,496126,3459,312 Notes: Firm and year FEs included. All explanatory variables lagged one year. Standard errors clustered by firm. Annual data from , except Implied Volatility (col 2) for

Empirical findings: Total Debt + Debt Maturity Total Debt(1)(2)(3)(4)(5) OLS IVOLSIV RealizedImpliedRealized Controls Uncertainty (volatility)-0.045***-0.061*** † *** (-3.918)(-2.578)(-1.345)(-2.938)(-0.510) F-test of 1 st stage Observations134,24622,7158,804125,5449,312 Short Term/Long Term(1)(2)(3)(4)(5) OLS IVOLSIV RealizedImpliedRealized Uncertainty (volatility)-0.103***-0.102*-0.405**-0.096***-0.474** (-3.558)(-1.554)(-2.085)(-3.242)(-2.085) F-test of 1 st stage Observations113,52118,1906,804108,6756,757 Notes: Firm and year FEs included. All explanatory variables lagged one year. Standard errors clustered by firm. Annual data from , except Implied Volatility (col 2) for

Empirical findings: Equity payout and Cash Cash Holding(1)(2)(3)(4)(5) OLS IVOLSIV RealizedImpliedRealized Uncertainty (volatility)0.078*** **0.073***0.120 † (3.357)(1.149)(2.306)(3.072)(1.332) F-test of 1 st stage121.38,493 Observations134,24622,7158,804125, Dividend + Stock Repur.(1)(2)(3)(4)(5) OLS IVOLSIV RealizedImpliedRealized Uncertainty (volatility)-0.006***-0.015***-0.017***-0.004*** (-5.344)(-7.303)(-4.431)(-4.269)(-0.646) F-test of 1 st stage108.66,757 Observations113,52118,1906,804108, Notes: Firm and year FEs included. All explanatory variables lagged one year. Standard errors clustered by firm. Annual data from , except Implied Volatility (col 2) for

Empirical summary following an uncertainty shock A.Factor accumulation (in capital and labor) falls B.Debt falls, particularly short-run debt C.Equity payout also falls, raising cash holding

1) Uncertainty and corporate financing policies 2) Model 3) Model insights

Real and financial adjustment costs dynamic model 1.A large cross section of heterogeneous firms 2.Firms choosing investment, short-term debt (cash) and long- debt to maximize firm value 3.Collateral constraints on debt Three shocks: A)Standard “TFP” first-moment shock B)Uncertainty shock (TFP second-moment shock) C)Financing shock (tougher collateral constraints)

Technology

Debt financing

Equity financing

1) Uncertainty and corporate financing policies 2) Model 3) Model results 20

Calibration: Real frictions

Calibration: Financial frictions

Simulation procedure Create monthly simulation data, and aggregate to yearly to produce accounts and yearly stock-volatility Run simulation for 3000 firms for 1000 months. Use last 600 months to generate 50 years of data (150,000 firm-year obs) Simulation estimations identical specification as real data, etc: Year and firm fixed-effects One-year lag on explanatory variables Clustered standard-errors

Quantitative results: benchmark model matches well RealFinancial VariablesI/KdEmpDebtShort/longCashDividend Data Volatility Benchmark model Volatility Notes: Simulation result on 3000 firms for 600 months (50 years) to yield 150,000 observations. Simulation data burnt in for 30 initial years to obtain an ergodic steady state. Simulated includes firm and year FEs, clustered SEs and same estimating specification as real data

Quantitative results: No financial frictions I/KDebtCashI/KDebtCash I. BenchmarkII. No financial adj. costs Volatility III. No financial shockIV. No fin shock & no fin adj. costs Volatility

Conclusions -Uncertainty shocks affect both real and financial activities in our panel data estimation (matching business/policy claims) -Theory shows that both financial and real frictions important, and they jointly amplify the impact uncertainty shocks -Ongoing work: -General Equilibrium model -Estimate the model using SMM

Back-Up

Quantitative results: No financial shock When shutting down financial shock, uncertainty effects on both real and financial activities are weaker by an order of magnitude RealFinancial VariablesI/KEmpDebtShort/longLong/total CashPayout Data Volatility [t] No financial shock Volatility [t]

Quantitative results: No financial frictions When shutting down debt adjustment costs, weaker effect on I/K and employment, and counterfactual prediction on debt maturity RealFinancial VariablesI/KEmpDebtShort/longLong/total CashPayout Data Volatility [t] No debt adjustment costs Volatility [t]

Quantitative results: No real frictions When shutting down capital adjustment costs, uncertainty effects are much weaker on real and financial activities RealFinancial VariablesI/KEmpDebtShort/longLong/total CashPayout Data Volatility [t] No capital adjustment cost Volatility [t]

Financial adjustment costs about 1/5 real adjustment costs All adjustment costs about 0.8% of annual sales