Optimal Capital Structure with Endogenous Default and Volatility Risk
AbstractThis paper analyzes the capital structure of a firm in an infinite time horizon following Leland (1994) under the more general hypothesis that the firm’s assets value process belongs to a fairly large class of stochastic volatility models. By applying singular perturbation theory, we fully describe the (approximate) capital structure of the firm in closed form as a corrected version of Leland (1994) and analyze the stochastic volatility effect on all financial variables. We propose a corrected version of the smooth-fit principle under volatility risk useful to determine the optimal stopping problem solution (i.e. endogenous failure level) and a corrected version for the Laplace transform of the stopping failure time. The numerical analysis obtained from exploiting optimal capital structure shows enhanced spreads and lower leverage ratios w.r.t. Leland (1994), improving results in a robust model-independent way.
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Bibliographic InfoPaper provided by Dipartimento di Matematica per le Decisioni, Universita' degli Studi di Firenze in its series DiMaD Working Papers with number 2012-02.
Length: 37 pages
Date of creation: Jan 2012
Date of revision:
structural model; stochastic volatility; volatility time scales; endogenous default; optimal stopping;
Find related papers by JEL classification:
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
- G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
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