Financial Contracting Along the Business Cycle
34 Pages Posted: 25 May 2003
Date Written: December 30, 2002
This paper suggests the existence of a relationship between business cycle fluctuations and firms' capital structure. The presence of asymmetric information in the loan market is responsible for endogenous fluctuations to take place at equilibrium. We depart from the more traditional endogenous cycles schemes in introducing a repeated lender-borrower interaction that allows for debt and equity financing to coexist in every period. We define sufficient conditions for the overall economy debt-equity ratio to exhibit a countercyclical behavior. This result is widely supported by several recent empirical finance studies. It also suggests a potential departure from the classic pecking order of financing theory.
Keywords: financial contracts, endogenous fluctuations, costly state verification
JEL Classification: E3, G3
Suggested Citation: Suggested Citation