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Abstract:
Firm size has been empirically found to be strongly positively related to capital structure. This paper investigates whether a dynamic capital structure model can explain the cross-sectional size-leverage relationship. The driving force that we consider is the presence of fixed costs of external financing that lead to infrequent restructuring and create a wedge between small and large firms. We find four firm-size effects on leverage. Small firms choose higher leverage at the moment of refinancing to compensate for less frequent rebalancings. Their longer waiting times between refinancings lead to lower levels of leverage at the end of restructuring periods. Within one refinancing cycle the intertemporal relationship between leverage and firm size is negative. Finally, there is a mass of firms opting for no leverage. The analysis of dynamic economy demonstrates that in cross-section the relationship between leverage and size is positive and thus fixed costs of financing contribute to the explanation of the stylized size-leverage relationship. However, the relationship changes sign when we control for the presence of unlevered firms.

Capital structure, leverage, firm size, transaction costs, default, dynamic programming, dynamic economy, refinancing point

Abstract:
Firm size has been empirically found to be strongly positively related to capital structure. A number of intuitive explanations can be put forward to account for this stylized fact, but none have been considered theoretically. This paper starts bridging this gap by investigating whether a dynamic capital structure model can explain the cross-sectional size-leverage relationship. The driving force that we consider is the presence of fixed costs of external financing that lead to infrequent restructuring and create a wedge between small and large firms. We find four firm size effects on leverage. Small firms choose higher leverage at the moment of refinancing to compensate for less frequent rebalancings. But longer waiting times between refinancings lead on average to lower levels of leverage. Within one refinancing cycle the intertemporal relationship between leverage and firm size is negative. Finally, there is a mass of firms opting for no leverage. The analysis of dynamic economy demonstrates that in cross-section the relationship between leverage and size is positive and thus fixed costs of financing contribute to the explanation of the stylized size-leverage relationship. However, the relationship changes the sign when we control for the presence of unlevered firms.

Capital structure, leverage, firm size, transaction costs, default, dynamic programming, dynamic economy, refinancing point, zero leverage

Abstract:
This paper tests the illiquidity premium hypothesis using U.S. Treasury securities intraday interdealer data. In contrast to the existing literature where notes are matched with bills in terms of maturity date, we compare notes with other notes maturing on the same day. One reason for comparing notes with notes rather than notes with bills is that differences in tax treatment across bills and notes could confront an experiment to measure the illiquidity effect. We find that notes are quoted at essentially identical prices despite substantial differences in their liquidity. This rejection of the hypothesis is in sharp contrast to the result of previous studies (Amihud and Mendelson, 1991). Therefore we reconsider the evidence based on matched bills and notes. We identify cross-sectional variation in bill-note pricing differences that cannot be supported by the illiquidity premium hypothesis. We also show that the pricing difference is smaller for matches with on-the-run bills, although the difference in liquidity between these bills and notes is significantly larger.

pricing, liquidity, market imperfections, bond markets, tax arbitrage

Abstract:
It is well known that structural models of credit risk provide poor predictions of bond prices. We show that they may perform much better as a predictor of debt return sensitivities to equity. This is important since it gives us an opportunity to identify much better the reasons for model failure. The main result of this paper is that even the simplest of the structural models (Merton (1974)) produces hedge ratios that are in line with those observed empirically. As well as providing insight into the determinants of corporate bond prices our results are also useful to practitioners who wish to hedge their positions in corporate debt. The paper also shows that corporate bond prices are sensitive to some variables - e.g., VIX - in a way that appears unrelated to credit risk.

Credit risk, structural models, hedge ratios, credit spreads

Abstract:
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.

Equity premium, corporate bond credit spread, predictability, macroeconomic conditions, jumps, capital structure, default

Abstract:
In the presence of frictions firms adjust their capital structure only infrequently. As a consequence, in a dynamic economy the leverage of most firms, most of the time, is likely to differ from the optimum leverage at the time of readjustment. This paper explores the empirical implications of this observation. A calibrated dynamic trade-off model with adjustment costs is used to simulate firms' capital structure paths. The results of standard cross-sectional tests on this data are found to be qualitatively - and, in some cases, even quantitatively - consistent with those reported in the empirical literature. In particular, the standard interpretation of some test results would lead to the rejection of the model used to generate the data. The framework can explain a number of observed puzzles related to leverage. In particular, in the simulated cross-sectional samples leverage: (a) is inversely related to profitability; (b) can be largely explained by stock returns; (c) is mean-reverting. The results suggest that, in the presence of infrequent adjustment, cross-sectional properties of economic variables in dynamics may be fundamentally different from those derived assuming that they are always at their target levels. Taken together, the results suggest a rethinking of the way capital structure tests are conducted.

capital structure, dynamic economy, trade-off model, simulations, asset liquidity, refinancing point, profitability, stock returns, credit

Abstract:
This paper documents the puzzling evidence that a substantial number of large public non-financial US firms follow a zero-debt policy. Over the 1962-2003 period, on average 9% of such firms have zero leverage and almost 23% have less than 5% quasi-market leverage ratio. Zero-leverage behavior is a persistent phenomenon. More than a quarter of zero-leverage firms refrain from debt for at least five consecutive years. We find that while zero-leverage firms are smaller than other firms in their industries, neither industry nor size explains their puzzling behavior. Particularly surprising is the presence of a large number of zero-leverage firms who pay dividends. Dividend-paying zero-leverage firms are more profitable, pay higher taxes and have higher cash balances than their proxies chosen by industry and size. These firms also pay substantially higher dividends than their proxies and thus the total payout ratio is relatively independent of leverage. We also find that age of the firm is unlikely to explain extreme debt-aversion behavior. We propose a number of economic explanations aiming to explain the empirical evidence and, by testing some of them, fail so far to provide any reasonable explanation of the puzzle.

Leverage, debt financing, capital structure, zero leverage, financing

Abstract:
Intuition suggests that firms with higher cash holdings are safer and should have lower credit spreads. Yet empirically, the correlation between cash and spreads is robustly positive and higher for lower credit ratings. This puzzling finding can be explained by the precautionary motive for saving cash. In our model endogenously determined optimal cash reserves are positively related to credit risk, resulting in a positive correlation between cash and spreads. In contrast, spreads are negatively related to the "exogenous" component of cash holdings that is independent of credit risk factors. Similarly, although firms with higher cash reserves are less likely to default over short horizons, endogenously determined liquidity may be related positively to the longer-term probability of default. Our empirical analysis confirms these predictions, suggesting that precautionary savings are central to understanding the effects of cash on credit risk.

Credit spreads, Default, Liquidity, Precautionary savings

Abstract:
Do strategic actions of borrowers and lenders affect corporate debt value? Our evidence indicates that they do, though the economic significance of the effect is limited. The possibility of renegotiation on average increases corporate debt spreads by 2-8 basis points due to the threat of strategic default, despite possible ex post efficiency gains to renegotiation. The impact is higher when the bondholders' bargaining position is likely to be weak, including firms with high managerial shareholding, simple debt structures, and high liquidation costs. On balance, although incorporating strategic behavior may improve the cross-sectional performance of debt pricing models, it is unlikely to remedy their inability to predict the general level of spreads.

credit spreads, strategic debt service, capital structure, credit risk, renegotiation, bargaining power

Abstract:
This paper develops a theory of multiple unit auctions with short squeezes in the post-auction market. This is especially relevant for financial and commodity markets where players may enter the auction with established forward positions. We study how a potential short squeeze impacts on bidders' strategies and auction performance. Conversely, we also study how the design of the auction affects the incidence of short squeezes. In particular, we model both uniform price and discriminatory price auctions in a true multiple unit setting, where bidders can submit multiple bids for multiple units. Our model is cast in what appears to be a common value framework. However, we show that the possibility of a short squeeze introduces different valuations of the to-be-auctioned asset between short and long bidders. Equilibrium bidding strategies depend on pre-auction allocations and the size of the auction. Short squeezes are more likely to happen after discriminatory auctions than after uniform auctions, ceteris paribus. Discriminatory auctions therefore lead to (1) more price distortion; (2) higher revenue for an auctioneer; (3) more volatility in the secondary market. This shows that a central bank or sovereign treasury, say, may face a tradeoff between revenue maximization and market distortions when choosing the design of repo or treasury auctions. The probability of a short squeeze following a discriminatory auction tends to decrease with the auction size, increase with the market power of the largest long bidders, and decrease with small long players' scope for free-riding on a short squeeze. Asymptotically, as the auction size becomes arbitrarily large, the two types of auctions lead to equivalent outcomes.

Multiple Unit Auction, Uniform auction, Discriminatory Auction, Treasury Auction, Repo Auction, Short Squeeze, Market Manipulation, Market Power

Abstract:
Repo auctions are multiunit auctions regularly used by central banks to inject liquidity into the banking sector. Banks have a fundamental need to participate, because they have to satisfy reserve requirements. Superficially, repo auctions resemble treasury auctions; the format and rules are similar, and there is an active secondary market for the underlying asset. Using a bidder level dataset of the European Central Bank's main repo auctions, however, we find evidence that the economic issues in repo auctions may be very different. Unlike what has been documented in the treasury auctions literature, we find no evidence that private information and the winner's curse are important issues. Instead, our findings suggest that bidders are more concerned with the loser's nightmare, collateral, and future interest rate reductions by the ECB. Small and large bidders use different strategies, with large bidders performing better.

Multiunit auctions, reserve requirements, loser's nightmare, money markets, collateral, repo auctions, central bank, open market operations

Abstract:
We study bidder behavior and performance in 53 main refinancing operations ("repo auctions") of the European Central Bank (ECB). The data set starts with the first auction after the ECB changed from fixed rate tenders to variable rate tenders. We find that private information and the winner's curse are not important in these auctions. The minimum bid rate and the level of secondary market rates play a crucial role in bidder behavior and auction performance. We also document that large bidders do better than small bidders, apparently because they use "smarter" strategies which involve using more bids and having more kurtosis in their individual bid distribution. The penultimate auction in every reserve maintenance period has less underpricing than the other auctions within the maintenance period. Finally, from the two cases of underbidding covered by the sample period, it appears this was driven by particularly large cutbacks by large, rather than small, bidders.

Repo auctions, multiunit auctions, discriminatory auctions, reserve requirements, money markets, central bank, interest rates, collateral, open market operations.

Abstract:
We study the impact of time-varying macroeconomic conditions on optimal dynamic capital structure and the aggregate dynamics of firms in a cross-section. Our structural-equilibrium framework embeds a contingent-claim corporate financing model within a standard consumption-based asset-pricing model. This enables us to investigate the effect of macroeconomic conditions on asset valuation and optimal corporate policies as well as study the impact of preferences on capital structure. We find that capital structure is pro-cyclical at refinancing dates when firms relever, but counter-cyclical in aggregate dynamics, consistent with empirical evidence. Financially constrained firms follow more pro-cyclical policies. Capital structure is path-dependent. Leverage accounts for most of the macroeconomic risk relevant for predicting defaults. The paper also develops a number of novel empirically testable conjectures on capital structure in a dynamic economy.

Dynamic capital structure, leverage, aggregate dynamics, cross-sectional behavior, default probability, financial constraints, macroeconomic risk, risk aversion, elasticity of intertemporal substitution

Abstract:
The paper models fixed rate tenders, where a central bank offers to lend central bank funds to financial institutions. Bidders are constrained by the amount of collateral they have. We focus on the strategic interaction between bidding in the tender and trading in the interbank market after the tender, where short squeezes could occur. We examine how the design of the tender affects equilibrium bidding behavior and the incidence of short squeezes. Important elements in the analysis include the type of policy implemented by the central bank as well as bidders' initial endowments of liquidity and collateral. Three instruments for softening short squeezes are identified: the tender rate, the tender sizes, and admissible collateral. Increasing the tender rate or size tends to decrease the probability and severity of a short squeeze. The possibility of a short squeeze may induce bidders to oversubscribe even if the tender rate is higher than the competitive rate.

Short squeeze, collateral, fixed rate tender, liquidity

Abstract:
Repo auctions are used to inject central bank funds against collateral into the banking sector. The ECB uses standard discriminatory auctions and hundreds of banks participate. The amount auctioned over the monthly reserve maintenance period is in principle exactly what banks collectively need to fulfil reserve requirements. We study bidder-level data and find: (i) Bidder behavior is different from what is documented for treasury auctions. Private information and the winner's curse seem to be relatively unimportant. (ii) Underpricing is positively related to the difference between the interbank rate and the auction minimum bid rate, with the latter appearing to be a binding constraint. (iii) Bidders are more aggressive when the imbalance of awards in the previous auction is larger. (iv) Large bidders do better than small bidders. Some of our findings suggests that bidders are concerned with the loser's nightmare and have limited amounts of the cheapest eligible collateral.

Repo auctions, Multiunit auctions, Reserve requirements, Loser's nightmare, Money markets, Central bank, Collateral, Open market operations

Abstract:
We investigate corporate financial policies in the presence of both temporary and permanent shocks to firms' cash flows. In our framework firms can experience negative cash flows, the changes in and levels of cash flows are imperfectly correlated with firm value, and earnings volatility is different from asset volatility. These results are consistent with empirical stylized facts and are opposite to the implications of existing dynamic capital structure models which allow only for permanent shocks to cash flows. Our results show that temporary shocks increase the importance of financial flexibility and may provide an intuitively simple and realistic explanation of empirically observed financial conservatism and low leverage phenomena. The theoretical framework developed in this paper is general enough to be used in various corporate finance applications.

Leverage, debt financing, capital structure, financing decisions, temporary and permanent shocks, mean-reversion, finance substitution

Abstract:
Since World War II, direct stock ownership by households has largely been replaced by indirect stock ownership by financial institutions. We argue that tax policy is the driving force. Using long time-series from eight countries, we show that the fraction of household ownership decreases with measures of the tax benefits of holding stocks inside a pension plan. This finding is important for policy considerations on effective taxation and for financial economics research on the long-term effects of taxation on corporate finance and asset prices.

Capital gains tax, income tax, stock ownership, inflation, bracket creep, pension funds

Abstract:
Intuition suggests that firms with higher cash holdings are safer and should have lower credit spreads. Yet empirically, the correlation between cash and spreads is robustly positive and higher for lower credit ratings. This puzzling finding can be explained by the precautionary motive for saving cash. In our model endogenously determined optimal cash reserves are positively related to credit risk, resulting in a positive correlation between cash and spreads. In contrast, spreads are negatively related to the "exogenous" component of cash holdings that is independent of credit risk factors. Similarly, although firms with higher cash reserves are less likely to default over short horizons, endogenously determined liquidity may be related positively to the longer-term probability of default. Our empirical analysis confirms these predictions, suggesting that precautionary savings are central to understanding the effects of cash on credit risk.

Credit spreads, Default, Liquidity, Precautionary savings

Abstract:
Since World War II, direct stock ownership by households has largely been replaced by indirect stock ownership by financial institutions. We argue that tax policy is the driving force. Using long time-series from eight countries, we show that the fraction of household ownership decreases with measures of the tax benefits of holding stocks inside a pension plan. This finding is important for policy considerations on effective taxation and for financial economics research on the long-term effects of taxation on corporate finance and asset prices.

Bracket creep, capital gains tax, Income tax, Inflation, Pension funds, stock ownership