Low Inflation: High Default Risk and High Equity Valuations

79 Pages Posted: 21 Feb 2019

See all articles by Beata Smarzynska Javorcik

Beata Smarzynska Javorcik

University of Oxford - Department of Economics

Christian Dorion

HEC Montreal; Canadian Derivatives Institute

Alexandre Jeanneret

UNSW Business School

Michael Weber

University of Chicago - Finance; National Bureau of Economic Research (NBER)

Date Written: 2018

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 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: E440, G120, G320, G330

Suggested Citation

Smarzynska Javorcik, Beata and Dorion, Christian and Jeanneret, Alexandre and Weber, Michael, Low Inflation: High Default Risk and High Equity Valuations (2018). CESifo Working Paper No. 7391, Available at SSRN: https://ssrn.com/abstract=3338745

Beata Smarzynska Javorcik (Contact Author)

University of Oxford - Department of Economics ( email )

Manor Road Building
Manor Road
Oxford, OX1 3BJ
United Kingdom

Christian Dorion

HEC Montreal ( email )

3000, Chemin de la Côte-Sainte-Catherine
Montreal, Quebec H2X 2L3
Canada
5143401522 (Phone)
5143405632 (Fax)

HOME PAGE: http://neumann.hec.ca/pages/christian.dorion/

Canadian Derivatives Institute ( email )

3000, chemin de la Côte-Sainte-Catherine
Montréal, Québec H3T 2A7
Canada

Alexandre Jeanneret

UNSW Business School ( email )

Sydney, NSW 2052
Australia

Michael Weber

University of Chicago - Finance ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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