Risk-taking with Financing Constraints

Title: Risk-taking with Financing Constraints

Abstract (preliminary): We study the impact of liquidity constraints on firms' risk-taking that depends on leveraged returns and leveraged volatility. We show that an easier liquidity condition may or may not encourage risk-taking. Following an interest-rate cut, fewer firms are willing to take risks if their leverage is low; more firms prefer to take risks if their leverage is high. The result highlights that liquidity policies can generate a non-linear effect on risk-taking and on social welfare. Therefore, in the aggregate, we can observe a non-monotone relationship between the interest rate and firm-return volatility. A cut in interest rate may not encourage firms to implement risky but socially desirable projects. A calibrated version of the model shows that an optimal (deposit) interest rate should be low around 0.3%-1.5%, which is robust to risk-spillover consideration.