Growth options, macroeconomic conditions, and the cross section of credit risk

Abstract

This paper develops a structural equilibrium model with intertemporal macroeconomic risk, incorporating the fact that firms are heterogeneous in their asset composition. Compared to firms that are mainly composed of invested assets, firms with growth options have higher costs of debt because they are more volatile and have a greater tendency to default during recession when marginal utility is high and recovery rates are low. Our model matches empirical facts regarding credit spreads, default probabilities, leverage ratios, equity premiums, and investment clustering. Importantly, it also makes predictions about the cross-section of all these features.Keywords: Asset composition, capital structure, credit spread puzzle, equity premium, growth options, macroeconomic risk, value premium $ We thank an anonymous referee whose suggestions have greatly improved the paper.

Investment‐Based Corporate Bond Pricing

“…The paper by Arnold, Wagner, and Westermann () is especially close to our work, as they also consider a setup with time‐varying macroeconomic risk and a stochastic discount factor based on Epstein‐Zin (1989) preferences. In contrast to our study, however, they do not test their empirical predictions and do not examine the cross‐section of credit risk premia.…”

“…However, contrary to our work, these papers do not focus on the pricing of corporate bonds and do not consider the importance of macroeconomic conditions. Barclay, Morellec, and Smith (), Chen and Manso (), and Arnold, Wagner, and Westermann () also explore the effects of growth options on credit risk. These papers consider a levered firm that finances a single growth option exclusively with equity.…”

Measuring Agency Costs over the Business Cycle

“…The economy is subject to intertemporal macroeconomic shocks. The structural tradeoff model is similar to that in Arnold, Wagner, and Westermann (2013); additionally, agency conflicts are introduced as in Morellec, Nikolov, and Schürhoff (2012).…”

“…The nominal cash flow growth rates and systematic volatilities correspond to the estimates by Bhamra, Kuehn, and Strebulaev (2010b) in a two regime-model. The idiosyncratic volatility is chosen as in Arnold, Wagner, and Westermann (2013) to reflect the average asset volatility. Further, recovery rates are set as α B = 0.7 and α R = 0.5.…”

“…In particular, the estimates imply that the mean sojourn time in booms is 64%. The parameters related to inflation and the parameters determining the stochastic discount factor are as in Arnold, Wagner, and Westermann (2013).…”