High Inflation: Low Default Risk and Low Equity Valuations

Abstract

We develop an asset-pricing model with endogenous corporate policies that explains how inflation
jointly impacts real asset prices and corporate default risk. Our model includes two empirically
founded nominal rigidities: fixed nominal debt coupons (sticky leverage) and sticky cash flows. These two frictions result in lower real equity prices and credit spreads when expected inflation rises. A decrease in expected inflation has opposite effects, with even larger magnitudes. In the cross-section, the model predicts that the negative impact of higher expected inflation on real equity values is stronger for low leverage firms. We find empirical support for the model’s predictions.

Keywords: high inflation, default risk, equity, leverage, credit spreads

JEL Classification: E44, G12, G32, G33