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Growth Options and Credit Risk

77 Pages Posted: 11 Jul 2016 Last revised: 1 Feb 2017

Andrea Gamba

University of Warwick - Finance Group

Alessio Saretto

University of Texas at Dallas - School of Management - Department of Finance & Managerial Economics

Date Written: January 31, 2017

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

Suggested Citation

Gamba, Andrea and Saretto, Alessio, Growth Options and Credit Risk (January 31, 2017). WBS Finance Group Research Paper. Available at SSRN: https://ssrn.com/abstract=2807300 or http://dx.doi.org/10.2139/ssrn.2807300

Andrea Gamba (Contact Author)

University of Warwick - Finance Group ( email )

Scarman Road
Coventry, CV4 7AL
Great Britain
+44 (0)24 765 24 542 (Phone)
+44 (0)24 765 23 779 (Fax)

Alessio Saretto

University of Texas at Dallas - School of Management - Department of Finance & Managerial Economics ( email )

800 Campbell Road
SM 31
Richardson, TX 75080
United States
972-883-5907 (Phone)

HOME PAGE: http://www.utdallas.edu/~axs125732

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