Low Inflation: High Default Risk AND High Equity Valuations
79 Pages Posted: 29 Nov 2018
Date Written: November 26, 2018
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 grounded nominal frictions: ﬁxed nominal coupons and sticky proﬁtability. Taken together, these two frictions result in higher real equity prices and credit spreads when inﬂation falls. An increase in inﬂation has opposite effects, but with smaller magnitudes. In the cross section, the model predicts the negative impact of inﬂation on real equity values is stronger for low leverage ﬁrms. We ﬁnd empirical support for the model predictions.
Keywords: low inﬂation, default risk, equity, leverage, credit spreads
JEL Classification: E44, G12, G32, G33
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