The Journal of Finance Forthcoming Article Abstract

View Full Article in

Abstract:
I build a dynamic capital structure model that demonstrates how business-cycle variations in expected growth rates, economic uncertainty, and risk premia influence firms' financing and default policies. Countercyclical fluctuations in risk prices, default probabilities, and default losses arise endogenously through firms' responses to the macroeconomic conditions. These comovements generate large credit risk premia for investment grade firms, which helps address the "credit spread puzzle" and "under-leverage puzzle" in a unified framework. The paper generates interesting dynamics for financing and defaults, including ``credit contagion'' and market timing of debt issuance. It also provides a novel procedure to estimate state-dependent default losses.