77 Pages Posted: 11 Jul 2016 Last revised: 1 Feb 2017
Date Written: January 31, 2017
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: 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