Growth Options and Credit Risk

Abstract

We structurally estimate a dynamic model of credit risk and analyze the relation between growth options and credit spreads. Our model features real and financing frictions, a technology with decreasing returns to scale, and endogenous investment options driven by both systematic and idiosyncratic shocks. We find a negative relation between credit spreads and growth options, after controlling for determinants of credit risk. The economic mechanism behind this negative relation is twofold: first, due to external financing needs and financing frictions, the current decision to invest and the associated change in leverage, increase credit spreads while reducing the value of future investments. Second, growth options accrue value mostly in response to firm-specific productivity shocks, thus decreasing the exposure of the firm to systematic risk and therefore decreasing credit risk premia.

Keywords: growth options, capital structure, credit risk, structural estimation

JEL Classification: G12, G32