How firm-level risk management and diversification shape business cycles
Traditional macroeconomic models treat aggregate shocks as exogenous forces imposed on the economy. Two recent working papers challenge this view, demonstrating that firms actively choose their risk profiles, and these choices collectively shape the very nature of business cycles and financial crises.
Alexandr Kopytov (University of Rochester), Mathieu Taschereau-Dumouchel (Cornell University) and Zebang Xu (Cornell University) in their paper “The Origin of Risk,” show how firms endogenously select the mean, variance, and covariance of their productivity processes. Aggregate risk arises when firms select productivity processes that are correlated with one another.
Rory Mullen ( University of Warwick) in his paper “On Aggregate Fluctuations, Systemic Risk, and the Covariance of Firm-Level Activity” documents that “covariances between firms’ growth rates drive most of the variance in aggregate productivity, sales, and profits”, explaining this through firms’ diversification across business lines.
- Firms actively choose their risk exposure by balancing productivity gains against risk management costs. Rather than passively accepting shocks, companies invest resources in hedging activities and risk infrastructure. Larger firms benefit from economies of scale in risk management, while firms facing fewer tax and regulatory distortions have stronger incentives to invest in sophisticated risk systems. This creates a natural sorting: large, efficient firms manage risk more aggressively, collectively shaping aggregate economic volatility.
- Using Spanish and U.S. firm data, the authors confirm their theory’s predictions. Larger firms exhibit 17 percentage points lower volatility than smaller ones, while firms with higher markups are 4 percentage points more volatile. Large firms are also less correlated with aggregate economic fluctuations, demonstrating successful risk management.
- Tax and regulatory distortions don’t just reduce efficiency—they increase systemic risk. When firms face higher wedges, they underinvest in risk management, making the entire economy more vulnerable to shocks. Removing these distortions enables optimal risk management investment, significantly reducing aggregate volatility.
- Mullen’s analysis of U.S. public firms reveals that covariances between firm growth rates explain 80-90% of aggregate economic variance. High-productivity firms contribute disproportionately to this covariance—over 13 times the median firm—yet create less systematic risk per dollar of market value.
- The Diversification Mechanism: High-productivity firms operate more business lines (2.6 vs. 1.5 segments on average), creating a trade-off: more diversified revenue streams increase firm value, but greater overlap with other firms’ technology choices increases systematic covariance. This explains why similar productivity firms exhibit higher correlations with each other.
- Resolving the Risk Paradox: The framework explains why high-productivity firms offer lower stock returns despite driving aggregate fluctuations. These firms operate some unique technologies that generate profits with little aggregate covariance contribution, making them less risky investments per dollar despite their size and influence on the economy.
- Kopytov et al. provide the microfoundation for why firms choose specific risk exposures through cost-benefit optimization
- Mullen offers empirical evidence for the covariance channel and demonstrates its asset pricing relevance
- Together, they explain both the incentives (endogenous risk management) and outcomes (observed covariance structures)
