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Dynamic optimal capital structure with regime switching

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  • Robert Elliott

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  • Jia Shen

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Abstract

We investigate the optimal capital structure of a corporate when the dynamics of the assets (both growth rate and volatility) change following different states of the economy. Two structural models are examined in the paper. The first considers the case when the firm is not facing tax benefit and bankruptcy costs with a regime switching dynamics. This model extends the Black and Cox (J Financ 31:351–367, 1976 ) model to allow for regime switching risk. The second model incorporates both tax benefit and bankruptcy costs with a regime switching dynamics. This is is more realistic, and is an extension of the Leland (J Financ 49(4):1213–1252, 1994 ) model with regime switching risk. We obtain closed-form analytic solutions for the optimal capital structure and default barrier for both models. Copyright Springer-Verlag Berlin Heidelberg 2015

Suggested Citation

  • Robert Elliott & Jia Shen, 2015. "Dynamic optimal capital structure with regime switching," Annals of Finance, Springer, vol. 11(2), pages 199-220, May.
  • Handle: RePEc:kap:annfin:v:11:y:2015:i:2:p:199-220
    DOI: 10.1007/s10436-015-0260-6
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    File URL: http://hdl.handle.net/10.1007/s10436-015-0260-6
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    References listed on IDEAS

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    1. Merton, Robert C., 1977. "On the pricing of contingent claims and the Modigliani-Miller theorem," Journal of Financial Economics, Elsevier, vol. 5(2), pages 241-249, November.
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    3. Leland, Hayne E, 1994. " Corporate Debt Value, Bond Covenants, and Optimal Capital Structure," Journal of Finance, American Finance Association, vol. 49(4), pages 1213-1252, September.
    4. Jones, E Philip & Mason, Scott P & Rosenfeld, Eric, 1984. " Contingent Claims Analysis of Corporate Capital Structures: An Empirical Investigation," Journal of Finance, American Finance Association, vol. 39(3), pages 611-625, July.
    5. Giesecke, Kay & Longstaff, Francis A. & Schaefer, Stephen & Strebulaev, Ilya, 2011. "Corporate bond default risk: A 150-year perspective," Journal of Financial Economics, Elsevier, vol. 102(2), pages 233-250.
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    11. Hayne E. Leland, 1998. "Agency Costs, Risk Management, and Capital Structure," Journal of Finance, American Finance Association, vol. 53(4), pages 1213-1243, August.
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    Citations

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    Cited by:

    1. Mengzhe Zhang & Leunglung Chan, 2016. "Saddlepoint approximations to option price in a regime-switching model," Annals of Finance, Springer, vol. 12(1), pages 55-69, February.
    2. Daniela Neykova & Marcos Escobar & Rudi Zagst, 2015. "Optimal investment in multidimensional Markov-modulated affine models," Annals of Finance, Springer, vol. 11(3), pages 503-530, November.

    More about this item

    Keywords

    Credit spread; Defaultable bond; Regime switching ; Structural model; First passage time; Markov chain; G12; G13; C58;

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics

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