Mind the Gap: The Market Price of Financial Flexibility

57 Pages Posted: 28 Aug 2023

See all articles by Filippo Ippolito

Filippo Ippolito

Universitat Pompeu Fabra - Faculty of Economic and Business Sciences; Barcelona Graduate School of Economics; Centre for Economic Policy Research (CEPR)

Roberto Steri

University of Luxembourg

Claudio Tebaldi

Bocconi University - CAREFIN - Centre for Applied Research in Finance; Bocconi University - Department of Finance; Bocconi University - IGIER - Innocenzo Gasparini Institute for Economic Research

Alessandro Villa

Federal Reserve Bank of Chicago

Date Written: August 27, 2023

Abstract

The empirical connection between financial leverage and equity risk premia is surprisingly weak. We link limited financial flexibility to levered risk premia with a quantitative model of firm dynamics, where firms make investment, financing, and default decisions facing idiosyncratic and aggregate risk. Our model spotlights two key variables, leverage gaps and leverage targets, as drivers of risk premia. Notably, leverage alone offers limited insights. Firms only partially close the gap toward their target, being optimally over- or under-levered. Equity holders of over-levered firms bear relatively higher costs of debt, as their capital structure is vulnerable to bankruptcy costs. Hence, leverage gaps contribute to the amplification of asset return fluctuations. The "lost" leverage risk premium reappears after controlling for targets, which instead lower risk premia. Based on the model predictions, we document novel empirical facts, underscoring limited financial flexibility as a plausible explanation for the contentious evidence concerning levered risk premia.

Keywords: firm dynamics, financial flexibility, financial frictions, heterogeneous firms, capital misallocation, cross section of returns, dynamic capital structure, risk premia

JEL Classification: G12, G32

Suggested Citation

Ippolito, Filippo and Ippolito, Filippo and Steri, Roberto and Tebaldi, Claudio and Villa, Alessandro, Mind the Gap: The Market Price of Financial Flexibility (August 27, 2023). Available at SSRN: https://ssrn.com/abstract=4553410 or http://dx.doi.org/10.2139/ssrn.4553410

Filippo Ippolito

Barcelona Graduate School of Economics ( email )

Ramon Trias Fargas, 25-27
Barcelona, Barcelona 08005
Spain

Universitat Pompeu Fabra - Faculty of Economic and Business Sciences ( email )

Ramon Trias Fargas 25-27
Barcelona, 08005
Spain
(+34) 93 542 2578 (Phone)
(+34) 93 542 1746 (Fax)

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Roberto Steri (Contact Author)

University of Luxembourg ( email )

Kirchberg, 6, rue Richard Coudenhove-Kalergi
Luxembourg
Luxembourg

HOME PAGE: http://https://sites.google.com/site/robertosteripersonalpage/

Claudio Tebaldi

Bocconi University - CAREFIN - Centre for Applied Research in Finance ( email )

Via Roentgen 1
Milan, 20136
Italy

Bocconi University - Department of Finance ( email )

Via Roentgen 1
Milano, MI 20136
Italy

Bocconi University - IGIER - Innocenzo Gasparini Institute for Economic Research ( email )

Via Roentgen 1
Milan, 20136
Italy

Alessandro Villa

Federal Reserve Bank of Chicago ( email )

230 South LaSalle Street
Chicago, IL 60604
United States

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