Risk-aversion, optimal leverage and the investment-uncertainty relation

We develop a partial equilibrium dynamic model in which firms are risk-averse. We analyse the determinants of the investment-uncertainty relationship by means of numerical techniques. When firms can borrow ¿outside¿ resources at the riskless rate, an increase in price volatility depresses investment for realistic parameter values. In our model, portfolio considerations play an important role. When the marginal revenue of capital becomes more uncertain, the risk-averse firm¿s owners reduce their ¿short position¿ in the risk-free asset, thus diminishing the firm¿s debt level. The contraction in leverage reduces the expected returns on investment because the expected marginal revenue product is higher than the user cost of capital. In turn, the reduction in expected returns tends to depress investment.