Macroeconomic Conditions and the Puzzles of Credit Spreads and Capital Structure
Journal of Finance, Forthcoming
58 Pages Posted: 30 Sep 2009
Date Written: September 25, 2009
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: capital structure, credit spread, default risk, business cycle, default losses
JEL Classification: E44, G12, G13, G32, G33
Suggested Citation: Suggested Citation