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Monetary Policy and Corporate Default
Abstract
When a corporation issues debt with a fixed nominal coupon, the real value of future payments decreases with the price level. Forward-looking corporate default decisions therefore depend on monetary policy through its impact on expected inflation. We build a general equilibrium economy with deadweight bankruptcy costs that demonstrates how nominal rigidities in corporate debt create an important role for monetary policy even in the absence of standard nominal frictions such as staggered price setting in the output market. Under a passive nominal interest rate peg, the direct effects of a negative pro- ductivity shock combine with deflation to produce strong incentives for corporate default. A debt-deflationary spiral results when there are real costs of financial distress. Inflation targeting eliminates this amplification mechanism but full inflation targeting requires permitting the nominal interest rate to depend explicitly on credit market conditions.
... One branch of the literature focuses on the link between expected inflation and default risk, but yields counterfactual implications for equity valuation. In Bhamra, Fisher, and Kuehn (2011), Kang and Pflueger (2015), and Gomes, Jermann, and Schmid (2016), higher expected inflation increases both the nominal risk-free rate and the expected growth rate of a firm's nominal cash flows. Both effects reduce firms' indebtedness and default risk, but these models predict a counterfactual increase in equity prices. ...
... This effect originates from the nominal debt coupons that are constant and, thus, not adjusted with expected inflation. 15 This is a direct consequence of the stickiness of leverage, as in Bhamra, Fisher, and Kuehn (2011), Kang and Pflueger (2015), and Gomes, Jermann, and Schmid (2016). ...
... Stickiness in leverage is the central driver of the negative relation between expected inflation and credit spreads, following the work of Table 2 and discussed in Section 4.1. Bhamra, Fisher, and Kuehn (2011), Kang and Pflueger (2015), and Gomes, Jermann, and Schmid (2016). 23 Importantly, when it comes to equity valuations, the default risk channel is not strong enough to fully counteract the discounting channel: equity valuations still fall as expected inflation rises. ...
We develop an asset pricing model with endogenous corporate policies that explains how inflation jointly affects real asset prices and corporate default risk. Our model includes two empirically founded nominal rigidities: fixed nominal debt coupons (sticky leverage) and sticky cash flows. These two frictions result in lower real equity prices and credit spreads when expected inflation rises. A decrease in expected inflation has opposite effects, with even larger magnitudes. In the cross-section, the model predicts that the negative impact of higher expected inflation on real equity values is stronger for low leverage firms. We find empirical support for the model’s predictions.
Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.
... In addition to dynamic structural models, we study two other approaches that generate persistence in credit spreads. The first relates to monetary policy and emphasizes the role of inflation and the stickiness of long-term debt to obtain persistence in credit spreads (Bhamra, Fisher, and Kuehn (2011)). The second, referred to as the financial accelerator, considers frictions in the credit supply and points to the role of debt collateral constraints as a factor of persistence after a first shock to productivity (Bernanke and Gertler (1989), Kiyotaki and Moore (1997)). ...
... acknowledge that their model generates insufficient comovement between credit spreads and equity returns volatility and points toward the monetary policy as a potential missing factor. Interestingly, the model ofBhamra, Fisher, and Kuehn (2011), which takes monetary effects into account, can also generate persistence in credit spread dynamics. In this structural model, corporate default decisions depend on monetary policy through its impact on expected inflation. ...
... The presence of deadweight bankruptcy costs amplifies what Bhamra, Fisher, and Kuehn (2011) call a debt-deflationary spiral.In this monetary framework, persistence in credit spreads is caused by the financ-ing frictions that emerge directly from the nature of long-term debt. Nevertheless, asBhamra, Fisher, and Kuehn (2011) acknowledge, other non-monetary types of financing frictions, such as shocks to the credit supply, can have a similar impact on credit spread dynamics. ...
Studies about credit spread switching regimes typically make assumptions about the number of regimes for in-sample regime detection. This is because exploratory regime detection techniques are lacking in the literature. We employ a real time sequential technique to detect possible breakpoints in the mean and the variance of credit spreads. Our evidence shows that regime shifts are closely related to systematic shocks. Detected shifts in the mean and the variance have different patterns that provide new insights on the relation between economic and credit cycles. We also show that the employed out-of-sample detection technique can be valuable for market timing.
... Therefore, we include the year-on-year percentage change in country-specific industrial production excluding construction (IP) to reflect that a contraction in economic activity tends to be associated with heightened corporate default risk (Lando and Nielsen (2010), Giesecke et al. (2011)). We also include the year-on year percentage change in the country-specific harmonized index of consumer prices (HICP) as our measure of inflation (Inf) to capture the contribution of low (expected) inflation to corporate default risk through a corresponding increase in real debt liabilities (Bhamra et al. (2011), Fiore et al. (2011, Gomes et al. (2016)). In addition, we incorporate the trailing one-year inflation volatility (InfVol) as Kang and Pflueger (2015) showed that it contributes significantly to explaining credit spread variations for a panel of G7 countries over the period 1970-2010. ...
... Inflation also contributes significantly to explaining variations in default risks across all sectors and horizons. While the positive sign of the coefficient estimates appears to be at odds with empirical evidence on low expected inflation predicting corporate defaults through its impact on real debt liabilities (Bhamra et al. (2011), Fiore et al. (2011, Gomes et al. (2016)), we conjecture that inflation -and its downward trend over the studied sample -contributes to explaining variations in default probabilities at the sector level by proxying for their trend component. Higher inflation volatility is associated with a significant decrease in default risk; consistent with the expectation that, in a low inflation environment, higher volatility would likely reduce the probability that firm will default due to higher real liabilities. ...
This paper studies the transmission of macroprudential policies across both financial and non-financial sectors of the economy. It first documents that tighter macroprudential regulations implemented in Europe over the period 2008–2017 lowered default risk not only in the financial, but also in non-financial sectors. Second, the paper analyzes the impact of two reforms in the macroprudential framework. Higher capital requirements improve the long-run resilience of the financial sector but at the cost of raising long-term default risk in non-financial sectors. Strengthening the resolution framework for failing banks has beneficial long-run effects on the default risks of the financial and non-financial sectors. Our results concur with the literature documenting how banks adjust their balance sheet composition and credit supply in reaction to changes in their regulatory environment.
... Regarding monetary policy's influence on firms' default through debt, two main direct channels stand out: (i) inflation and (ii) leverage. Bhamra et al. (2011) note that corporations that issue fixed rate debt have incentives to default through the influence of monetary policy on a decrease in expected inflation. Gonzalez-Aguado and Suarez (2015) relax the rigidity of the capital structure and build a model in which the policy rate changes the firms' target leverage and, as a result, the aggregate default. ...
... We highlight now two articles that explain the influence of rates on default risk without relying on bank loan supply frictions. Bhamra et al. (2011) explain that fixed-income corporate obligations with a fixed nominal coupon increase the incentives of firms to default due to the monetary policy influence on expected inflation. In the dynamic model of Gonzalez-Aguado and Suarez (2015), the effect of monetary policy on default rates is heterogeneous across firms in the short-term. ...
This study documents the relationship between foreign monetary policy and firms' ex-ante forward-looking default probability measures. We analyze market-based measures of default for large non-financial firms in the US and the EMU area. We propose two transmission mechanisms of foreign policy shocks: the foreign demand channel and the foreign debt channel. We show that foreign monetary policy influences firms' default probability largely through the foreign demand channel. We find that the foreign debt channel only played a role for European firms during the early 2000s due to the higher exposure to USD denominated obligations. These results highlight the need for macro-prudential authorities to pay more attention to the foreign demand channel in the struggle against large default events, as the results show that the foreign debt channel is less relevant.
... The impulse response functions are based on averaging 1,000 simulated series each variable. 8 The dynamic adjustment of macroeconomic variables to a nominal interest rate shock is broadly consistent with empirical impulse-responses (e.g. Christiano et al., 2005). ...
... The evidence that motivates our analysis is based on data collected after the Volcker shock, during which the Taylor principle is commonly agreed to have been satis…ed. 8 Dynare generates IRFs using the approximate policy functions as follows: (i) It draws a series of the all the exogenous shocks for a number of 100 + T periods, where T is the number of periods shown in the IRF graphs, here T = 15: (ii) It performs a simulation 'S1'of all the variables of interest using this realization of the shocks. (iii) It changes the sequence of exogenous shocks, by adding a one-standard deviation of the shock we are interested in, here ", to the realization of period 101, (iv) It performs a new simulation 'S2'of all variables based on the new sequence of shocks. ...
Empirical literature documents that unexpected changes in the nominal interest rates have a significant effect on real stock prices: a 100-basis point increase in the nominal interest rate is associated with an immediate decrease in broad real stock indices that may range from 2.2 to 9%, followed by a gradual decay as real stock prices revert towards their long-run expected value. We assess the ability of a general equilibrium New Keynesian asset-pricing model to account for these facts. We consider a production economy with elastic labor supply, staggered price and wage setting, as well as time-varying risk aversion through habit formation. We find that the model predicts a stock market response to policy shocks that matches empirical estimates, both qualitatively and quantitatively. Our findings are robust to a range of variations and parametrizations of the model.
... Regarding monetary policy's influence on firms' default through debt, two main direct channels stand out: (i) inflation and (ii) leverage. Bhamra et al. (2011) note that corporations that issue fixed rate debt have incentives to default through the influence of monetary policy on a decrease in expected inflation. Gonzalez-Aguado and Suarez (2015) relax the rigidity of the capital structure and build a model in which the policy rate changes the firms' target leverage and, as a result, the aggregate default. ...
... We highlight now two articles that explain the influence of rates on default risk without relying on bank loan supply frictions. Bhamra et al. (2011) explain that fixed-income corporate obligations with a fixed nominal coupon increase the incentives of firms to default due to the monetary policy influence on expected inflation. In the dynamic model of Gonzalez-Aguado and Suarez (2015), the effect of monetary policy on default rates is heterogeneous across firms in the short-term. ...
This study documents the relationship between foreign monetary policy and firms' ex-ante forward-looking default probability measures. We analyze market based measures of default for large non-financial firms in the US and the EMU area. We propose two transmission mechanisms of foreign policy shocks: the foreign demand channel and the foreign debt channel. We show that foreign monetary policy influences firms' default probability largely through the foreign demand channel. We find that the foreign debt channel only played a role for European firms during the early 2000s due to the higher exposure to USD denominated obligations. These results highlight the need for macro-prudential authorities to pay more attention to the foreign demand channel in the struggle against large default events, as the results show that the foreign debt channel is less relevant.
... Further, the episode under observation is associated with a period of deflation (see Masiyandima et al. 2018). Deflation upsurges the real values of money and debt, making it more burdensome for borrowers to pay back the borrowed funds since they will be using stronger dollars to repay their loans (see Fleckenstein et al. 2017;Tokic 2017;Mahonde 2016;Bhamra et al. 2011). Additionally, deflation depresses expenditure, and as a result, corporations receive lower revenues, and their profits become depressed. ...
Using stepwise logistic regression models, the study aims to separately detect and explain the determinants of default probability for unaudited and audited small-to-medium enterprises (SMEs) under stressed conditions in Zimbabwe. For effectiveness purposes, we use two separate datasets for unaudited and audited SMEs from an anonymous Zimbabwean commercial bank. The results of the paper indicate that the determinants of default probability for unaudited and audited SMEs are not identical. These determinants include financial ratios, firm and loan characteristics, and macroeconomic variables. Furthermore, we discover that the classification rates of SME default prediction models are enhanced by fusing financial ratios and firm and loan features with macroeconomic factors. The study highlights the vital contribution of macroeconomic factors in the prediction of SME default probability. We recommend that financial institutions model separately the default probability for audited and unaudited SMEs. Further, it is recommended that financial institutions should combine financial ratios and firm and loan characteristics with macroeconomic variables when designing default probability models for SMEs in order to augment their classification rates.
... A small number of current studies on the factors influencing the debt default phenomenon have been conducted mainly from two perspectives: the external environment and internal management. From the perspective of the firm's external environment, as far as the macro context is concerned, it has long been established that both macroeconomic and market information significantly affect firms' financial distress (Shumway, 2001), that the financial cycle plays an important role in firms' debt defaults (Luo & Li, 2020), and that the impact of monetary policy on expected inflation also acts on firms' debt default phenomenon (Bhamra et al., 2011). In the case of microentities, government relief may lead to an increased likelihood of corporate moral hazard and debt default . ...
The phenomenon of corporate debt default has broken out in recent years, which highlights the importance of the macro situation to the stability of business operations. In this paper, the debt default of A-share listed companies in Shanghai and Shenzhen Stock Exchange from 2008 to 2018 are used as a sample to conduct a research from the perspective of independent directors with macro vision. The empirical results show that the larger the number and the higher the proportion of macro-background independent directors in bond issuing companies, the less debt default will be found; moreover, the relationships are stronger when enterprises face more economic uncertainty and higher systemic risk. Meanwhile, independent director with macro vision mainly reduces the company’s default risk. The above results not only provide new evidence for the advisory role of independent directors, but also supplement the influencing factors of debt default.
... Apart from the aforementioned internal determinants of capital structure, there is considerable research on various external predictors of the target capital structure in the form of macroeconomic indicators [26][27][28]. Several studies have shown a significant association between corporate capital structure and the current gross domestic product (GDP) (e.g. ...
Objective. This study aims to connect two strands of the psychology and economics literature, i.e., behavioural finance and agent-based macroeconomics, to assess the impact of managerial overconfidence at the micro and macro levels of the economy as a whole.
Method. We build a macroeconomic stock-flow consistent agent-based model that is calibrated for the specific case of Poland to explore whether the overconfidence of top corporate managers in the context of their initial capital structure decisions is detrimental for the firms being managed in this way, the financial market dynamics, and the selected macroeconomic indicators. We model heterogeneous firms with different capital structure decision criteria depending on their degree of managerial overconfidence. Our model also includes a complete macroeconomic closure with aggregated households, capital producers, banking, and a public sector.
Results. We find that firms with overconfident managers outperform in terms of investment and size but are also more fragile, thereby making them more likely to default. Finally, we run policy shocks and show that while investors’ flight to liquidity creates financial turmoil and increases the probability of default.
Conclusions. This paper contributes to the knowledge base by linking behavioural corporate finance and agent-based macroeconomics. In general, the excess overconfidence on the micro level, either an increase in the proportion of overconfident firms or a higher degree of overconfidence among managers, has a strong destabilizing impact on the economy as a whole on the macro level.
... The equilibrium conditions would all become intertwined, leading to a fixed-point problem that could only be solved using a linear approximation system (e.g., seeBhamra, Fisher, and Kuehn (2011),Gomes and Schmid (2011)).39 Modeling firm assets would then require deriving the density at which firm revenue reaches a barrier for the first time, where the firm revenue growth rate depends on a second first-passage time problem involving an imperfectly correlated state variable. ...
This paper develops a two-country asset pricing model with defaultable firms and governments. This model shows that higher sovereign credit risk in a country depresses equity prices internationally and increases their volatility. The effect is strongest during adverse economic conditions and when firms are close to financial distress. A structural estimation provides evidence that sovereign default risk in Europe affects European and U.S. stock markets through the threat of an economic slowdown.
... Nominal interest rate peg is an extreme form of stabilization which sets the short-term interest rate equal to a constant target plus noise (Bhamra, Fisher & Kuehn, 2011). So called passive policy as it does not respond to inflation. ...
The aim of this study is to indicate the influence of macroeconomic factors on corporate capital structure in different European countries. The recent Global Financial Crisis and the following European debt crisis show the significance of the country financial stability, consequently the efficiency of fiscal and monetary policies, and their impact on the private sector. The macroeconomic policies of a country affect the financial performances of the companies and their future sustainable development and growth. We analyze the influence of external determinants on the corporate capital structure of non-financial manufactured companies based on the evidence from European developed countries and emerging markets for the period 2006–2010, in order to compare the level of the impact on the capital structure according to the countries’ specifics. The managers make their financial decisions according to the source of financing and capital structure based on the company's advantages and disadvantages, i.e. its internal characteristics, and doubtless on the macroeconomic conditions and country specifics, i.e. external factors. For the purpose of this study the macroeconomic factors are divided into two groups represented fiscal and monetary policies of a country. The correlation and regression techniques are used to identify the relations between these external determinants and capital structure. The findings show the significance of macroeconomic factors in the decision making process regarding capital structure and the source of financing.
... The shift in the level occurs if the current value tested Z cur is outside the critical threshold 14 We previously check that the filtered data do not suffer from statistical issues related to the distribution of the data in each regime, heteroskedasticity of the residuals and square residuals. These issues are further discussed in Maalaoui Chun et al (2013). ...
Using a real-time random regime shift technique, we identify and discuss two different regimes in the dynamics of credit spreads during 2002–2012: a liquidity regime and a default regime. Both regimes contribute to the patterns observed in credit spreads. The liquidity regime seems to explain the predictive power of credit risk on the 2007–2009 NBER recession, whereas the default regime drives the persistence of credit spreads over the same recession. Our results complement the recent dynamic structural models as well as monetary and credit supply effects models by empirically supporting two important patterns in credit spreads: the persistence and the predictive ability toward economic downturns. Régimes de risque de défaut de paiement et de liquidité dans le marché obligataire pour la période 2002–2012. A l'aide d'une technique de changement aléatoire de régime en temps réel, on identifie et on examine deux régimes différents dans la dynamique des écarts de crédit entre 2002 et 2012 : un régime de liquidité et un régime de risque de défaut de paiement. Les deux régimes contribuent à expliquer les patterns observés d'écarts de crédit. Le régime de liquidité semble expliquer le pouvoir de prédiction du risque de crédit sur la récession au sens du NBER de 2007–2009, alors que le régime de risque de défaut de paiement explique la persistance des écarts de crédit au cours de la même récession. Ces résultats complètent les travaux récents sur les modèles structurels dynamiques ainsi que sur les modèles des effets de l'offre de monnaie et de crédit, en supportant empiriquement deux patterns dans les écarts de crédit : la persistance et la capacité à prédire les tendances à la baisse dans l'activité économique.
This study thoroughly investigates how, and to what extent, macroeconomic conditions interact with corporate default in the US industrial sector from 1980 to 2014. Using an extensive data set of macro-level and micro-level variables, we construct five categories of indicators and measure macroeconomic conditions by investigating co-movements within each category of indicator. We find macroeconomic conditions have bidirectional causal interaction with corporate defaults across different economic regimes, reflecting the existence of feedback causality. Moreover, we find that macroeconomic indicator constructed using the least absolute shrinkage and selection operator (LASSO) approach shows superior explanatory power as well as predictive power for default clustering, indicating that movements of these indicators cause correlated changes in firms' default rates. Overall, our study provides support for literature on default probability estimation from a macroeconomic perspective.
Based on the data of Shanghai and Shenzhen A-share listed companies from 2009 to 2018, we explore the impact of delayed disclosure of annual report on the accuracy of financial distress prediction. We find that the information of disclosure delay can significantly improve the accuracy of financial distress prediction. After using alternative measurement of the disclosure delay and considering the endogeneity problem, our conclusions are robust. Our study provides reference for regulatory authorities to standardize the companies’ disclosure behaviours and prevent and resolve their major risks.
Using daily credit default swap (CDS) data, we find a positive relation between corporate credit risk and unexpected monetary policy shocks during FOMC announcement days. Positive shocks to interest rates increase the expected loss component of CDS spreads as well as a risk premium component. However, not all firms respond in the same manner. We show that firm-level credit risk is an important driver of the monetary policy response, both in credit and equity markets, and its role is not diminished by the inclusion of other risk proxies. A stylized corporate model of monetary policy, investment, and financing rationalizes our findings.
This paper presents empirical evidence that the maturity structure of financial leverage affects the cross‐section of equity returns. We find that short‐term leverage is associated with a positive premium, whereas long‐term leverage is not. The premium for short‐term compared to long‐term leverage reflects higher exposure of equity to systematic risk. To rationalize our findings, we show that the same patterns emerge in a model of debt rollover risk with endogenous leverage and debt maturity choice. Our results suggest that analyses of leverage effects in asset prices and corporate financial applications should account for the maturity structure of debt. This article is protected by copyright. All rights reserved
I study the sufficiency of macroeconomic information to explain the time-variation in second moments of stock and bond returns, with a particular attention to stock-bond correlations. I propose an external habit model supplemented with realistic non-Gaussian fundamentals estimated solely from macroeconomic data. Intertemporal smoothing and precautionary savings effects – driven by consumption shocks – combine with a time-varying covariance between consumption and inflation to generate large positive and negative stock-bond return correlations. Macroeconomic shocks are most important in explaining second moments of stock and bond returns from the late 1970’s to mid-1990’s and during the Great Recession.
This study examines the effect of macroeconomic factors on investor reactions in the capital market with internal financial decisions and company performance as the intervening variables. Previous studies examined only the effect of macroeconomic factors on direct market reactions. The sample of this research are manufacturing companies listed on the Indonesia Stock Exchange. Structural Equation Modeling (SEM) was tested using SmartPLS. This study concludes that financial decisions and company performance are not the intervening variables between macroeconomic factors and market reactions. Macroeconomic factors do not affect the company's internal financial decisions and company performance but the market reaction. Meanwhile, the company's internal financial decisions have no effect on the company's performance and market reaction. The company's performance affects the market reaction. The results of this study prove that investors are very concerned about macroeconomic factors in making investment decisions. The dynamics of macroeconomic factors directly influence investment decisions in the capital market.
We show that, despite the sharp but temporary decline around the financial crisis of 2007–08, corporate debt maturity has risen significantly in the last two decades, erasing much of the secular decline from the 1980–90s documented in the literature. The reversal in debt maturity trend is driven by the rise in the use of intermediate-term debt among medium and large-sized firms. The low interest rates observed in the last two decades and the decline in the demand for long-term corporate bonds partly explains the rise in intermediate-term debt.
We investigate the impact of monetary policy shocks on excess corporate bonds returns. We obtain a significant negative response of bond returns to policy shocks, which is especially strong among low-grading bonds. The largest portion of this response is related to higher expected bond returns (risk premium news), while the impact on expectations of future interest rates (interest rate news) plays a secondary role. However, the interest rate channel is dominant among high-grading bonds and Treasury bonds. Looking at the two components of bond premium news, we find that the dominant channel for high-rating (low-rating) bonds is term premium (credit premium) news. (JEL 44, E52, G10, G12)
Received: March 25, 2019: Editorial decision: March 27, 2020 by Editor: Hui Chen. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.
In this article, we study the relationship between monetary policy and corporate bankruptcies in the USA. The main hypothesis is that an increase in the monetary base or a decrease in the federal funds rate reduces the probability of corporate bankruptcies. The main intuition lies in the economic mechanism through which both of these actions accelerate inflation and lower the real value of corporate debt. The results strongly support the main hypothesis of the paper. In addition, we also study the impact of other macroeconomic variables on bankruptcy rates. Our findings show that the total reserves of depositary institutions and the overall performance of the US corporate sector are negatively related to the frequency of corporate failures.
The paper quantifies the influence of interest rates and inflation rates on default rates of banks. By expanding the work of Duffee (1998), with the unspanned risks as in the work of Joslin, Priebsch, and Singleton (2014), we estimate a multifactor model with unspanned interest rates and inflation rates to test the performance of unspanned variables in the default rate term structure of banks. The model is trained in samples of positive interest rates and evaluated in samples of negative interest rates. we check the robustness of the model by comparing the results with the performance of alternative model specifications. The model reveals that unspanned variables have worse performance than alternative models specifications. The negative effect of interest rates on default rates over longer maturities may lead the EA banks to decrease the loan supply to the real economy. As a consequence EA banks will have a lower net interest margin as the return of assets is lower. This may increase the future probability of default. Thus, the solution for EA banks is on the reach to yield behavior as described by Bruno and Shin (2015). This means that EA banks have to modify the allocation of assets more in favour of riskier and longer maturity securities to obtain higher profitability.
Purpose
The purpose of this paper is to investigate the role of banking sector concentration, banking sector development and equity market development in corporate financial flexibility (FF).
Design/methodology/approach
The study used annual data for the period from 1991 to 2014 to examine the relationship between banking sector concentration, banking sector development, equity market development and corporate FF; hypotheses were tested using an unbalanced panel logistic regression model.
Findings
The paper provides empirical insights into the relationships between macroeconomic factors and corporate FF. The results suggest a substantial change in FF across firms; banking sector concentration discourages firms from borrowing, leading to the reduction of corporate borrowing, consequently an increase in FF can be observed. Banking sector development facilitates debt financing, hence reducing FF. Equity market development also has a positive impact on FF, as it is a substitute for debt financing.
Practical implications
The banking sector is an important provider of capital to business entities. A concentrated banking system discourages the provision of capital to firms; hence regulators have to take appropriate measures to resolve the problem of a reduced supply of capital. Banking sector development facilitates the provision of capital; further development may reduce bank lending rates to firms. Equity market development positively affects FF; hence, firm managers can use equity financing to resume FF. By following pecking order theory, managers use internal sources to finance value-maximizing investment projects, debt and issue shares as the last choice to get financing. When borrowing capacity is depleted, managers can obtain further funds by issuing stocks.
Originality/value
FF is an emergent area of research in advanced countries, while in developing economies, it is in the initial stages. Little work is available in this area to find the impact of banking sector concentration, banking sector development and equity market development, therefore, this study fills this gap in the existing literature.
Purpose
The purpose of this study is to empirically examine the extent to which volatility associated with corporate performance could be attributed to specific adverse macroeconomic conditions in a bivariate causality analysis.
Design/methodology/approach
The study uses the Toda–Yamamoto Wald test approach to Granger causality analysis in verifying significant causal interactions if any, between corporate performance volatility and seven macroeconomic conditions or variables.
Findings
This study finds that economic policy uncertainty and macroeconomic uncertainty tend to have bidirectional causal interaction with corporate performance volatility. In addition, estimated results further suggest significant unidirectional causal interaction between corporate performance volatility and inflation expectations, exchange rate volatility, inflation and inflation uncertainty, with direction of causality running from the macroeconomic variables toward corporate performance volatility. This study, however, found no significant causal interaction between corporate performance volatility and recessionary probability or likelihood of recession.
Practical implications
This study’s conclusions could have significant and critical policy implications for key corporate policymakers responsible for corporate performance strategy. Various causal interactions identified could inform policy framework and, subsequently, strategies geared toward minimizing volatility associated with performance during episodes of any of the various macroeconomic conditions examined in this study.
Originality/value
The uniqueness of this study stems from its focus on corporate performance volatility instead of corporate performance and potential causal interactions it might have with key adverse macroeconomic conditions, some of which have not been examined in previous studies according to reviewed literature.
The cost of equity is an essential element of a business' financial decision-making process, which is influenced by a number of internal and external factors. This study intends to answer the question on how Czech CFOs perceive the impact of overall-economic and firm-specific factors on the cost of equity. The survey was carried out in 2015 and our sample covers 40 respondents. The findings show that there is a gap between the theory and practice and that the country’s specifics, in particular the low level of the financial market development, play a significant role in the perception of cost of equity capital determinants. First, the most commonly used cost of equity estimation approach is based on average historical returns. A considerably large number of the CFOs think that the ownership structure, dividend policy, ability to forecast financial results, stability of company´s earnings and flexibility in capital raising are the internal factors with the most significant impact on the cost of equity. Otherwise, a rather low number of respondents consider the information asymmetry, corporate governance and financial performance as having a strong influence on the cost of equity. In regard to the external factors, a substantial majority of the respondents acknowledges that the long-and short-term interest rates as well as inflation, sovereign debt and risks linked to the banking system and financial market strongly affect the cost of equity. © 2019, Kauno Technologijos Universitetas. All rights reserved.
We develop a structural credit model to examine how interactions between default and liquidity affect corporate bond pricing. The model features debt rollover and bond-price-dependent holding costs. Over the business cycle and in the cross-section, the model matches average default rates and credit spreads in the data, and captures variations in bid-ask and bond-CDS spreads. A structural decomposition reveals that default-liquidity interactions can account for 10%–24% of the level of credit spreads and 16%–46% of the changes in spreads over the business cycle. Further, liquidity-related corporate bond financing costs amount to 6% of the total issuance amount from 1996 to 2015.
Received July 12, 2015; editorial decision April 15, 2017 by Editor Andrew Karolyi.
Authors have furnished an Internet Appendix, which is available on the Oxford University Press website next to the link to the final published paper online.
The behavioural agent-based framework of De Grauwe and Gerba (2015) is extended to allow for a counterfactual exercise on the role of banks for monetary transmissions. A bank-based corporate financing friction is introduced and the relative contribution of that friction to the effectiveness of monetary policy is evaluated. We find convincing evidence that the monetary transmission channel is stronger in the bank-based system compared to the market-based. Impulse responses to a monetary expansion are around the double of those in the market-based framework. The (asymmetric) effectiveness of monetary policy in counteracting busts is, on the other hand, relatively higher in the market-based model. The statistical fit of the bank-based behavioural model is also improved compared to the benchmark model. Lastly, we find that a market-based (bankbased) financing friction in a general equilibrium produces highly asymmetric (symmetric) distributions and more (less) pronounced business cycles.
This study examines the impact of stock trading on capital structure using a sample of Tunisian publicly traded firms over the period 2002-2012. The study uses General least square regressions. Our results show that macroeconomic variables related to monetary policy and Fiscal policy have an impact on leverage. This relationship is positive for the case of Interest Rate (INT) and Unemployment Rate (UR) and negative for the case of Inflation Rate (IR). Moreover, we found that this relationship is robust for short term book leverage. However, for the long term, we found that only Interest Rate and Unemployment Rate have strong positive impact on leverage.
Originality/value–This is the first paper that examines the relationship between Macroeconomics determinants and capital structure in Tunisia.
Since its publication, the seminal structural model of default by Merton (1974) has become the workhorse for gaining insights about how firms choose their capital structure, a quotbread and butterquot topic for financial economists. Capital structure theory is inevitably linked to several important empirical issues such as (a) the term structure of credit spreads, (b) the level of credit spreads implied by structural models in relation to the ones that we observe in the data, (c) the cross-sectional variations in leverage ratios, (d) the types of defaults and renegotiations that one observes in real life, (e) the manner in which investment and financial structure decisions interact, (f) the link between corporate liquidity and corporate capital structure, (g) the design of capital structure of banks [contingent capital (CC)], (h) linkages between business cycles and capital structure, etc. The literature, building on Merton's insights, has attempted to tackle these issues by significantly enhancing the original framework proposed in his model to make the theoretical framework richer (by modeling frictions such as agency costs, moral hazard, bankruptcy codes, renegotiations, investments, state of the macroeconomy, etc.) and in greater accordance with stylized facts. In this review, I summarize these developments.
Asset-return implications of nominal price and wage rigidities are analyzed in general equilibrium. Nominal rigidities, combined with permanent productivity shocks, increase expected excess returns on production claims. This is mainly explained by consumption dynamics driven by rigidity-induced changes in employment and markups. An interest-rate monetary policy rule affects asset returns. Stronger (weaker) rule responses to inflation (output) increase expected excess returns. Policy shocks substantially increase asset-return volatility. Price rigidity heterogeneity produces cross-sectoral differences in expected returns. The model matches important macroeconomic moments and the Sharpe ratio of stock returns, but only captures a small fraction of the observed equity premium.
We argue that corporate bond yields reflect fears of debt deflation. When debt is nominal, unexpectedly low inflation increases real liabilities and default risk. In a real business cycle model with optimal but infrequent capital structure choice, more uncertain or pro-cyclical inflation leads to quantitatively important increases in corporate log yields in excess of default-free log yields. A panel of credit spread indexes from six developed countries shows that credit spreads rise by 14 basis points if inflation volatility or the inflation-stock correlation increase by one standard deviation.
US sovereign debt is widely regarded as risk-free on nominal terms. However, between January 2008 and September 2010, US sovereign credit default swaps (CDS) traded at premium to a sample of US corporate CDSs. The implied default probabilities from CDS premiums show that the US government is more likely to default than these firms. We find no evidence that changes in fundamental default risk are responsible for this premium difference. Traditional explanations such as differences in recovery rates, counterparty risk and cheapest-to-deliver options also cannot explain it. Changes in comovement “factors” that represent spillover effects from the default risk of European countries, and liquidity, appear to drive the observed premium difference.
We develop a tractable general equilibrium model that captures the interplay between nominal long-term corporate debt, inflation, and real aggregates. We show that unanticipated inflation changes the real burden of debt and, more significantly, leads to a debt overhang that distorts future investment and production decisions. For these effects to be both large and very persistent, it is essential that debt maturity exceeds one period. We also show that interest rate rules can help stabilize our economy.
Recent empirical literature documents that unexpected changes in the nominal interest rates have a significant effect on stock prices: a 25-basis point increase in the Fed funds rate is associated with an immediate decrease in broad stock indices that may range from 0.5 to 2.3 percent, followed by a gradual decay as stock prices revert towards their long-run expected value. In this paper, we assess the ability of a general equilibrium New Keynesian asset-pricing model to account for these facts. The model we consider allows for staggered price and wage setting, as well as time-varying risk aversion through habit formation. We find that the model predicts a stock market response to policy shocks that matches empirical estimates, both qualitatively and quantitatively. Our findings are robust to a range of variations and parameterizations of the model.
Using an innovative random regime shift detection methodology, we identify and confirm two distinct regime types in the dynamics of credit spreads: a level regime and a volatility regime. The level regime is long lived and shown to be linked to Federal Reserve policy and credit market conditions, whereas the volatility regime is short lived and, apart from recessionary periods, detected during major financial crises. Our methodology provides an independent way of supporting structural equilibrium models and points toward monetary and credit supply effects to account for the persistence of credit spreads and their predictive power over the business cycle.
This study examines the behavior of spreads paid in firm underwritten seasoned common stock offerings and straight bond offerings.
Estimates indicate that up to 85% of the spread is variable cost and that the marginal spread is rising. Further, offerings
that are likely to require greater underwriting services encounter higher marginal spreads. These findings are consistent
with there being a family of U-shaped spreads, with lower quality offerings priced on higher spreads, unlike the economies
of scale view of spreads. They agree with the views that underwriters provide valuable services and that the marginal cost
of external finance is rising.
A standard statistical perspective on the U.S. Great Inflation is that it involves an increase in the stochastic trend rate of inflation, defined as the long-term forecast of inflation at each point in time. That perspective receives support from two sources: the behavior of long-term interest rates which are generally supposed to contain private sector forecasts, and statistical studies of U.S. inflation dynamics. We show that a textbook macroeconomic model delivers such a stochastic inflation trend, when there are shifts in the growth rate of capacity output, under two behavioral hypotheses about the central bank: (i) that it seeks to maintain output at capacity; and (ii) that it seeks to maintain continuity of the short-term interest rate. The theory then identifies major upswings in trend inflation with unexpectedly slow growth of capacity output. We interpret the rise of inflation in the U.S. from the perspective of this simple macroeconomic framework.
We augment a standard monetary DSGE model to include a banking sector and financial markets. We fit the model to Euro Area and US data. We find that agency problems in financial contracts, liquidity constraints facing banks and shocks that alter the perception of market risk and hit financial intermediation — ‘financial factors’ in short — are prime determinants of economic fluctuations. They have been critical triggers and propagators in the recent financial crisis. Financial intermediation turns an otherwise diversifiable source of idiosyncratic economic uncertainty, the ‘risk shock’, into a systemic force.
In this paper we explore the impact of long- run risks in cash ow and consumption growth on optimal corporate default and capital struc- ture decisions, the term structure of credit spreads and actual default probabilities, and the levered equity risk premium. We do this by embedding a structural model of credit risk and dynamic corporate nancing decisions in a consumption-based representative-agent asset pricing model. The resulting unied framework has the advantage that it can be used to study the interplay between corporate nance and as- set pricing. In contrast with many previous studies, which consider an individual rm at its renancing point, our framework incorporates rm-level heterogeneity in capital structure deci-
The equity premium consists of a term premium reflecting the longer maturity of equity relative to short-term bills, and a risk premium reflecting the stochastic nature of equity payoffs and the deterministic nature of payoffs on riskless bills. This paper analyzes term premia and risk premia in a general equilibrium model with catching up with the Joneses preferences and a novel formulation of leverage. Closed-form solutions for moments of asset returns are derived. First-order approximations illustrate the effects of parameters and provide an algorithm to match the means and variances of the riskless rate and the rate of return on equity.
This article demonstrates that the dispute between Texaco and Pennzoil over the Getty Oil takeover reduced the combined wealth of the claimants on the two companies by over $3 billion. During the course of the litigation, Pennzoil's shareholders gained only one-sixth as much as Texaco's shareholders lost. When the litigation was settled, about two-thirds of the loss in wealth was regained. These fluctuations in value exceed most estimates of the direct costs of carrying on the litigation, and may reflect the disruption in the operations of Texaco caused by the dispute.
This paper departs from the representative-agent assumption and investigates how optimal monetary policy should be conducted in a two-agent New Keynesian (TANK) model. Relative to a price stability motive that typically appears as policy prescriptions in representative-agent New Keynesian (RANK) models, heterogeneity adds a motive to spread aggregate fluctuations equally across all households. We show that the latter motive hinges on how fiscal transfers are implemented with the business cycle.
We present a consumption-based model that explains a wide variety of dynamic asset pricing phenomena, including the procyclical variation of stock prices, the long-horizon predictability of excess stock returns, and the countercyclical variation of stock market volatility. The model captures much of the history of stock prices from consumption data. It explains the short- and long-run equity premium puzzles despite a low and constant risk-free rate. The results are essentially the same whether we model stocks as a claim to the consumption stream or as a claim to volatile dividends poorly correlated with consumption. The model is driven by an independently and identically distributed consumption growth process and adds a slow-moving external habit to the standard power utility function. These features generate slow countercyclical variation in risk premia. The model posits a fundamentally novel description of risk premia: Investors fear stocks primarily because they do poorly in recessions unrelated to the risks of long-run average consumption growth.
I integrate under firm-specific benefit functions to estimate that the capitalized tax benefit of debt equals 9.7 percent of firm value (or as low as 4.3 percent, net of personal taxes). The typical firm could double tax benefits by issuing debt until the marginal tax benefit begins to decline. I infer how aggressively a firm uses debt by observing the shape of its tax benefit Function. Paradoxically, large, liquid, profitable Firms with low expected distress costs use debt conservatively. Product market factors, growth options, low asset collateral, and planning for future expenditures lead to conservative debt usage. Conservative debt policy is persistent.
We estimate the equity premium using dividend and earnings growth rates to measure the expected rate of capital gain. Our estimates for 1951 to 2000, 2.55 percent and4.32 percent, are much lower than the equity premium produced by the average stock return,7.43 percent. Our evidence suggests that the high average return for 1951 to 2000 is due to a decline in discount rates that produces a large unexpected capital gain. Our main conclusion is that the average stock return of the last half-century is a lot higher than expected.
Prepared for The Encyclopedia of Business Cycles.
This chapter develops a dynamic general equilibrium model that is intended to help clarify the role of credit market frictions in business fluctuations, from both a qualitative and a quantitative standpoint. The model is a synthesis of the leading approaches in the literature. In particular, the framework exhibits a “financial accelerator”, in that endogenous developments in credit markets work to amplify and propagate shocks to the macroeconomy. In addition, we add several features to the model that are designed to enhance the empirical relevance. First, we incorporate money and price stickiness, which allows us to study how credit market frictions may influence the transmission of monetary policy. In addition, we allow for lags in investment which enables the model to generate both hump-shaped output dynamics and a lead-lag relation between asset prices and investment, as is consistent with the data. Finally, we allow for heterogeneity among firms to capture the fact that borrowers have differential access to capital markets. Under reasonable parametrizations of the model, the financial accelerator has a significant influence on business cycle dynamics.
Is inflation targeting suitable for the United States? Given that the Federal Reserve has not announced an explicit inflation target, how does one answer that question? If the answer is that inflation targeting is not suitable for the United States, what follows? Does the central bank not control inflation? Alternatively, if the central bank does control inflation, is there no need in a democracy for the central bank to make public its intentions with respect to inflation? Some members of the Federal Open Market Committee (FOMC) who have opposed an explicit inflation target have also answered the question of whether the central bank controls inflation in the affirmative. So there is something too simplistic about the follow-up question about central bank accountability. Surely, there is something more to the opposition than a desire to avoid accountability. Laurence Meyer (2001: 12), when a Federal Reserve governor, explained the complication as follows: The most important question that has to be addressed in order to assess the costs and benefits of a move in this direction [announcement of an explicit numerical inflation target] is whether it could be accomplished without reducing the flexibility the Fed now has to pursue a dual mandate. The Fed’s Dual Mandate What is the dual mandate? The Federal Reserve Act instructs the Fed “to promote effectively the goals of maximum employment [and] stable prices. ” However, the language is vacuous. “Maximum employment” suggests a target of 100 percent labor force participation. Even
We explore the bond-pricing implications of an exchange economy where (i) preference shocks result in time-varying term premiums in real yields, and (ii) a monetary policy Taylor rule determines inflation and nominal term premiums. A calibrated version of the model matches the observed term structure of both the mean and volatility of yields. In addition, unlike a comparable model with exogenous inflation, a Taylor rule that matches the properties of observed inflation creates nominal term premiums that remain volatile even at long maturities. Experiments with different parameter values for the Taylor rule demonstrate that the nominal term premiums can be highly sensitive to monetary policy, and that the recent decrease in the level and volatility of the nominal yields could be the result of a more aggressive monetary policy.
Credit markets play an important role in the macroeconomy and credit market data is often used to predict future macroeconomic performance. In this paper we propose a tractable general equilibrium asset pricing model with heterogeneous firms that links movements in stock and bond markets to macroeconomic activity. The model suggests that movements in risk premia in corporate bond markets are an important determinant of aggregate fluctuations. We show that movements in credit and term spreads forecast recessions by predicting future movements in corporate investment. Endogenous movements in credit markets allow our model to match the observed conditional and unconditional movements in stock market returns and credit spreads with a reasonable amount of aggregate volatility.
We model the debt and asset risk choice of a manager with performance-insensitive pay (cash) and performance-sensitive pay (stock) to theoretically link compensation structure, leverage, and credit spreads. The model predicts that optimal leverage trades off the tax benefit of debt against the utility cost of ex-post asset substitution and that credit spreads are increasing in the ratio of cash-to-stock. Using a large cross-section of U.S.-based corporate credit default swaps (CDS) covering 2001 to 2006, we find a positive association between cash-to-stock and CDS rates, and between cash-to-stock and leverage ratios.
We empirically examine whether firms engage in a dynamic rebalancing of their capital structures while allowing for costly adjustment. We begin by showing that the presence of adjustment costs has significant implications for corporate financial policy and the interpretation of previous empirical results. After confirming that financing behavior is consistent with the presence of adjustment costs, we find that firms actively rebalance their leverage to stay within an optimal range. Our evidence suggests that the persistent effect of shocks on leverage observed in previous studies is more likely due to adjustment costs than indifference toward capital structure.
We consider the desirability of modifying a standard Taylor rule for interest rate policy to incorporate adjustments for measures of financial conditions. We consider the consequences of such adjustments for the way policy would respond to a variety of disturbances, using the dynamic stochastic general equilibrium model with credit frictions developed in Cúrdia and Woodford (2009a). According to our model, an adjustment for variations in credit spreads can improve upon the standard Taylor rule, but the optimal size of adjustment depends on the source of the variation in credit spreads. A response to the quantity of credit is less likely to be helpful. Copyright (c) 2010 The Ohio State University.
We study the impact of time-varying macroeconomic conditions on optimal dynamic capital structure for a cross-section of firms. Our structural-equilibrium framework embeds a contingent-claim corporate financing model within a consumption-based asset-pricing model. We investigate the effect of macroeconomic conditions on asset valuation and optimal corporate policies, and of preferences on capital structure. While capital structure is pro-cyclical at dates when firms re-lever, it is counter-cyclical in aggregate dynamics, consistent with empirical evidence. We also find that financially constrained firms choose more pro-cyclical policies and that leverage accounts for most of the macroeconomic risk relevant for predicting defaults, but is a poor measure of how preferences impact capital structure. The Author 2010. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org., Oxford University Press.
This paper develops a framework for analyzing the impact of macroeconomic conditions on credit risk and dynamic capital structure choice. We begin by observing that when cash flows depend on current economic conditions, there will be a benefit for firms to adapt their default and financing policies to the position of the economy in the business cycle phase. We then demonstrate that this simple observation has a wide range of empirical implications for corporations. Notably, we show that our model can replicate observed debt levels and the countercyclicality of leverage ratios. We also demonstrate that it can reproduce the observed term structure of credit spreads and generate strictly positive credit spreads for debt contracts with very short maturities. Finally, we characterize the impact of macroeconomic conditions on the pace and size of capital structure changes, and debt capacity.
The paper reconsiders the role of money and banking in monetary policy analysis by including a banking sector and money in an optimizing model otherwise of a standard type. The model is implemented quantitatively, with a calibration based on US data. It is reasonably successful in providing an endogenous explanation for substantial steady-state differentials between the interbank policy rate and (i) the collateralized loan rate, (ii) the uncollateralized loan rate, (iii) the T-bill rate, (iv) the net marginal product of capital, and (v) a pure intertemporal rate. We find a differential of over 3% p.a. between (iii) and (iv), thereby contributing to resolution of the equity premium puzzle. Dynamic impulse response functions imply pro- or counter-cyclical movements in an external finance premium that can be of quantitative significance. In addition, they suggest that a central bank that fails to recognize the distinction between interbank and other short rates could miss its appropriate settings by as much as 4% p.a. Also, shocks to banking productivity or collateral effectiveness call for large responses in the policy rate.
The reduction in inflation that occurred in the early 1980s, when the Federal Reserve was headed by Paul Volcker, is arguably the most widely discussed and visible macroeconomic event of the last 50 years of U.S. history. Inflation had been dramatically rising, but under Volcker, the Fed first contained and then reversed this process. Using a simple modern macroeconomic model, we argue that the real effects of the Volcker disinflation were mainly due to its imperfect credibility. In our view, the observed upward volatility and subsequent stubborn elevation of long-term interest rates during the disinflation are key indicators of that imperfect credibility. Studying transcripts of the Federal Open Market Committee recently released to the public, we find—to our surprise—that Volcker and other FOMC members likewise regarded the long-term interest rates as indicative of inflation expectations and of the credibility of their disinflationary policy. Drawing from the transcripts and other contemporary sources, we consider the interplay of monetary targets, operating procedures, and credibility during the Volcker disinflation.
I present new evidence on the direct costs of bankruptcy and violation of priority of claims. In a sample of 37 New York and American Stock Exchange firms that filed for bankruptcy between November 1979 and December 1986, direct costs average 3.1% of the book value of debt plus the market value of equity, and priority of claims is violated in 29 cases. The breakdown in priority of claims occur primarily among the unsecured creditors and between the unsecured creditors and equity holders. Secured creditors' contracts are generally upheld.
Restrictions that a class of general equilibrium models place upon the average returns of equity and Treasury bills are found to be strongly violated by the U.S. data in the 1889–1978 period. This result is robust to model specification and measurement problems. We conclude that, most likely, an equilibrium model which is not an Arrow-Debreu economy will be the one that simultaneously rationalizes both historically observed large average equity return and the small average risk-free return.
This paper discusses the definition and mechanics of central bank interest rate smoothing under rational expectations. A tension arising between interest rate smoothing and macroeconomic stabilization objectives induces non-trend-stationary price level and money stock behavior. The paper thereby helps explain why such nominal non-stationarities are widely observed. Further implications are drawn for base drift, distribution of real returns on long-term fixed-rate nominal debt, and operating characteristics of interest rate pegs and policy instruments.
We develop a model of staggered prices along the lines of Phelps (1978) and Taylor (1979, 1980), but utilizing an analytically more tractable price-setting technology. ‘Demands’ are derived from utility maximization assuming Sidrauski-Brock infinitely-lived families. We show that the nature of the equilibrium path can be found out on the basis of essentially graphical techniques. Furthermore, we demonstrate the usefulness of the model by analyzing the welfare implications of monetary and fiscal policy, and by showing that despite the price level being a predetermined variable, a policy of pegging the nominal interest rate will lead to the existence of a continuum of equilibria.
During the early months of 2003, there was something of a buzz in monetary policy circles about the prospect of a move toward inflation targeting as a policy regime for the Federal Reserve. One leading manifestation was a prominent article in the Wall Street Journal on March 31 concerning the different points of view recently expressed by Fed Governors Ben Bernanke and Donald Kohn.1 Of course, there was little or no direct disputation; the WSJ article was based on substantial comments presented by Bernanke and Kohn at different conferences but released at about the same time. Kohn’s comments were delivered at a January 24-25 conference, sponsored by the National Bureau of Economic Research, at which he was the formal discussant of a paper by Marvin Goodfriend (2003).2 The specific item by Bernanke, mentioned in the WSJ article, is evidently his speech given at a March 25 conference of the National Association of Business Economists. Although there has not been direct disputation, there are significant differences of opinion expressed in the two Governors’ writings, as well as the paper by Goodfriend, differences that mirror important issues and call out for discussion.
This paper revisits the theoretical relation between financial leverage and stock returns in a dynamic world where both corporate investment and financing decisions are endogenous. We find that the link between leverage and stock returns is more complex than static textbook examples suggest, and depends on the investment opportunities available to the firm. In the presence of financial market imperfections, leverage and investment are generally correlated so that highly levered firms are also mature firms with relatively more (safe) book assets and fewer (risky) growth opportunities. A quantitative version of our model matches several stylized facts about leverage and returns. Copyright (c) 2010 the American Finance Association.
We embed a structural model of credit risk inside a dynamic continuous-time consumption-based asset pricing model, which allows us to price equity and corporate debt in a unified framework. Our key economic assumptions are that the first and second moments of earnings and consumption growth depend on the state of the economy, which switches randomly, creating intertemporal risk, which agents prefer to resolve sooner rather than later, because they have Epstein-Zin-Weil preferences. Agents optimally choose dynamic capital structure and default times. For a dynamic cross-section of firms, our model endogenously generates a realistic average term structure and time series of actual default probabilities and credit spreads, together with a reasonable levered equity risk premium, which varies with macroeconomic conditions. The Author 2009. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org, Oxford University Press.
I build a dynamic capital structure model that demonstrates how business-cycle variations
in expected growth rates, economic uncertainty, and risk premia influence firms’ financing and
default policies. Countercyclical fluctuations in risk prices, default probabilities, and default
losses arise endogenously through firms’ responses to the macroeconomic conditions. These
comovements generate large credit risk premia for investment grade firms, which helps address
the “credit spread puzzle” and “under-leverage puzzle” in a unified framework. The model
generates interesting dynamics for financing and defaults, including “credit contagion” and
market timing of debt issuance. It also provides a novel procedure to estimate state-dependent
default losses.
We estimate firm-specific marginal cost of debt functions for a large panel of companies between 1980 and 2007. The marginal cost curves are identified by exogenous variation in the marginal tax benefits of debt. The location of a given company’s cost of debt function varies with characteristics such as asset collateral, size, book-to-market, asset tangibility, cash flows, and whether the firm pays dividends. By integrating the area between benefit and cost functions we estimate that the equilibrium net benefit of debt is 3.5% of asset value, resulting from an estimated gross benefit of debt of 10.4% of asset value and an estimated cost of debt of 6.9%. We find that the cost of being overlevered is asymmetrically higher than the cost of being underlevered and that expected default costs constitute approximately half of the total ex ante cost of debt.
How do movements in the distribution of income and wealth affect the macroeconomy? We analyze this question theoretically, using numerical methods, in the context of a calibrated version of the stochastic growth model with partially uninsurable idiosyncratic risk and movements in aggregate productivity.
We solve the first general equilibrium model of lumpy investment allowing a quantitative match with recent empirical evidence on establishment-level investment dynamics. In our model, establishments are subject to both persistent aggregate and persistent idiosyncratic shocks, and they face nonconvex adjustment costs and irreversibilities that lead them to pursue asymmetric generalized (S,s) investment policies. Previous partial equilibrium analysis suggests that this class of model embeds mechanisms that yield empirically relevant aggregate nonlinearities. While the aggregate implications of lumpy investment are very sensitive to general equilibrium, we find that the inclusion of idiosyncratic shocks yields plant-level investment dynamics that are essentially unaffected by movements in interest rates. If idiosyncratic shocks are a relatively significant source of uncertainty, this suggests there may be minimal loss in the common practice of analyzing investment dynamics under a fixed interest rate assumption, provided that attention is confined to microeconomic implications. However, we show that there is a tension in referencing large idiosyncratic uncertainty as the basis for partial equilibrium examinations of the consequences of lumpy investment. Specifically, even small idiosyncratic shocks sharply reduce the role of nonconvexities in explaining establishment-level investment. Related to this, we find that, even in disequilibrium, aggregate nonlinearities arise only when idiosyncratic shocks are small relative to aggregate shocks.
Recent studies argue that the spread-adjusted Taylor rule (STR), which includes a response to the credit spread, replicates monetary policy in the United State. We show (1) STR is a theoretically optimal monetary policy under heterogeneous loan interest rate contracts in both discretionay and commitment monetary policies, (2) however, the optimal response to the credit spread is ambiguous given the financial market structure in theoretically derived STR, and (3) there, a commitment policy is effective in narrowing the credit spread when the central bank hits the zero lower bound constraint of the policy rate.
How do movements in the distribution of income and wealth affect the macroeconomy? We analyze this question using a calibrated version of the stochastic growth model with partially uninsurable idiosyncratic risk and movements in aggregate productivity. Our main finding is that, in the stationary stochastic equilibrium, the behavior of the macroeconomic aggregates can be almost perfectly described using only the mean of the wealth distribution. This re- sult is robust to substantial changes in both parameter values and model specification. Our benchmark model, whose only difference from the representative-agent framework is the existence of unin- surable idiosyncratic risk, displays far less cross-sectional dispersion
The authors construct a model of a dynamic economy in which lenders cannot force borrowers to repay their debts unless the debts are secured. In such an economy, durable assets play a dual role: not only are they factors of production but they also serve as collateral for loans. The dynamic interaction between credit limits and asset prices turns out to be a powerful transmission mechanism by which the effects of shocks persist, amplify, and spill over to other sectors. The authors show that small, temporary shocks to technology or income distribution can generate large, persistent fluctuations in output and asset prices. Copyright 1997 by the University of Chicago.
A model of dynamic capital structure is proposed. Even though the optimal strategy is implemented over an arbitrarily large number of restructuring-periods, a scaling feature inherent in the framework permits simple closed-form expressions to be obtained for equity and debt prices. When a firm has the option to increase future debt levels, tax advantages to debt increase significantly, and both the optimal leverage ratio range and predicted credit spreads are more in line with what is observed in practice. Copyright 2001 by University of Chicago Press.
The articles in this symposium cover some of the most active areas of research in macroeconomics. By design, each article is structured to present both a theoretical framework and empirical evidence. Through this structure, the articles synthesize recent developments, present new results, and provide guidance on avenues for further research. Earlier versions of these papers were presented at the Economic Fluctuations research meeting of the National Bureau of Economic Research on October 22 and 23, 1993. All papers were subject to the peer referee process that is standard at the 'Review of Economics and Statistics.' The 'Review' gratefully acknowledges the efforts of Professor Russell Cooper of Boston University and Professor Steven Durlauf of the University of Wisconsin (Madison), who volunteered their services to work as special co-editors for this symposium, with the assistance of the chair of the board of editors of the 'Review,' James Stock. Copyright 1996 by MIT Press.
Financial stability is an important goal of policy, but the relation of financial stability to economic performance and even
the meaning of the term itself are poorly understood. This paper explores these issues in a theoretical model. We argue that
financial instability, or fragility, occurs when entrepreneurs who want to undertake investment projects have low net worth;
the heavy reliance on external finance that this implies causes the agency costs of investment to be high. High agency costs
in turn lead to low and inefficient investment. Standard policies for fighting financial fragility can be interpreted as transfers
that maintain or increase the net worth of potential borrowers.