Working Paper: NBER ID: w16151
Authors: Hui Chen
Abstract: 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.
Keywords: credit spreads; capital structure; macroeconomic conditions; default policies
JEL Codes: E44; G12; G13; G32; G33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| macroeconomic conditions (E66) | firms' financing behavior (G32) |
| recessions (E32) | increased default losses (G33) |
| recessions (E32) | present value of expected default losses (G33) |
| macroeconomic shocks (F41) | default waves (E32) |
| procyclical cash flows (E32) | lower leverage (G19) |
| countercyclical cash flows (E32) | higher leverage (G32) |
| economic downturns (F44) | higher default probabilities (G33) |