Credit Risk and Dynamic Capital Structure Choice
AbstractThis Paper analyses the effect of dynamic capital structure adjustments on credit risk. Firms may optimally adjust their leverage in response to stochastic changes in firm value. It is shown that capital structure dynamics lower optimal initial leverage ratios but increase both fair credit spreads and expected default probabilities for moderate levels of transactions costs. Numerical examples demonstrate that expected default frequencies do not decrease monotonically in the traditional distance to default measure. The magnitude of the effect of capital structure dynamics depends on firm characteristics such as asset volatility, the growth rate, the effective corporate tax rate, debt call features and transactions costs. We find that the underestimation of credit spreads and expected default frequencies is exacerbated when the risk-adjusted drift of the underlying stochastic process is inferred from a model which ignores the opportunity to recapitalize. Finally it is shown that the Value-at-Risk of corporate bonds increases with the distance to default (DD) both for very low and for very high values of DD whereas it decreases for intermediate values.
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Bibliographic InfoPaper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 4132.
Date of creation: Dec 2003
Date of revision:
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Other versions of this item:
- D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
- G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
- G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
This paper has been announced in the following NEP Reports:
- NEP-ALL-2004-02-29 (All new papers)
- NEP-CFN-2004-02-29 (Corporate Finance)
- NEP-FIN-2004-02-29 (Finance)
- NEP-RMG-2004-02-29 (Risk Management)
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