sovereign default risk and the u s equity market i develop a two country general equilibrium model with firms governments and endogenous default decisions this paper shows that the risk of sovereign default abroad is important in the explanation of the level and the volatility of u s equity returns the intuition is that negative economic shocks deteriorate the fiscal situation of foreign governments thereby increasing the risk of a sovereign default that would trigger a local contraction in economic growth the rise in the risk of an economic slowdown abroad amplifies the direct eect of these shocks on the level and the volatility of equity returns in the u s through i a decrease in the present value of future firm earnings due to the unfavorable adjustment of the real exchange rate for u s exporters and ii a fall in u s equity prices that originates from the investors incentive to rebalance their portfolio towards risk free securities the amplification eect is strongest during periods of financial distress when the risk of corporate default is high in the u s a structural estimation of the model provides strong support for this prediction using monthly data for brazil and the u s over the period 1994 2008

real options agency conflicts and optimal capital structure abstract we examine the impact of a stockholder bondholder conflict over the timing of the exercise of an investment option on firm value and corporate financial policy we find that an equity maximizing firm exercises the option too early relative to a value maximizing strategy and we show how this problem can be characterized as one of overinvestment in risky investment projects equityholders incentive to overinvest significantly decreases firm value and optimal leverage and significantly increases the credit spread of risky debt numerical solutions illustrate how the agency cost of overinvestment and its effect on corporate financial policy vary with firm and project characteristics

evaluating natural resource investments notwithstanding impressive advances in the theory of finance over the past 2 decades practical procedures for capital budgeting have evolved only slowly the standard technique which has remained unchanged in essentials since it was originally proposed see dean 1951 bierman and smidt 1960 derives from a simple adaptation of the fisher 1907 model of valuation under certainty under this technique expected cash flows from an investment project are discounted at a rate deemed appropriate to their risk and the resulting present value is compared with the cost of the project this standard textbook technique reflects modern theoretical developments only insofar as estimates of the discount rate may be obtained from crude application of single period asset pricing theory but see brennan 1973 bogue and roll 1974 turnbull 1977 constantinides 1978 the inadequacy of this approach to capital budgeting is widely acknowledged although not widely discussed its obvious deficiency is its the evaluation of mining and other natural resource projects is made particularly difficult by the high degree of uncertainty attaching to output prices it is shown that the techniques of continuous time arbitrage and stochastic control theory may be used not only to value such projects but also to determine the optimal policies for developing managing and abandoning them the approach may be adapted to a wide variety of contexts outside the natural resource sector where uncertainty about future project revenues is a paramount concern

investment under uncertainty with strategic debt service the presence of a well designed bankruptcy code is an important part of the nancialarchitecture in developed economies by allowing the creditors to seize the assets of theborrowers who fail to make contractual payments the code generates bene cial ex ante e ectson debt capacity and rm value by giving the borrowers options to renegotiate their debtobligations and seek bankruptcy protection the code increases the likelihood that borrowersmay avoid ine cient ex post liquidation as hart 1999 notes the code should balanceex ante rm value maximization with ex post e ciency the bankruptcy codes in di erentcountries weight this tradeo di erently and hence vary in terms of the distribution of rightsand powers between borrowers and lenders in this paper we provide an inter temporal framework to examine how the creditors liquidation rights and the distribution of ex post bargaining powers in uence the rm s in vestment and nancing decisions and a ect ex ante rm value we show that strongerequityholders bargaining power lowers debt capacity reduces rm value and discouragesgrowth option exercising our calibration suggests that the quantitative e ects of ex poststrategic renegotiation on ex ante rm value may be large our paper provides an attempt to integrate nancial architecture into the theory of in vestment growth option exercising by building on two strands of literature investment anddebt pricing we extend the real options approach to investment pioneered by mcdonaldand siegel 1986 and brennan and schwartz 1985 to allow for capital structure decisionsunder strategic debt service we also draw insights from corporate debt pricing capital struc ture literature which focuses on leverage and security pricing after investment has alreadybeen made merton 1974 black and cox 1976 and leland 1994 our paper bridgesthe gap between these two strands of literature by characterizing the optimal investment and nancing decisions and the option value of waiting in closed form we show that the inter action between nancing and investment decisions in the presence of strategic debt servicegenerates new insights and also quantitatively important e ects on ex ante rm value

optimal financial policy and firm valuation since the classic work of miller and modigliani 1961 laid down the principles for the valuation of firms under conditions of certainty some two decades ago academic interest in the problem of valuing the individual firm has waned yet in addition to the obvious importance of this problem for security analysts investors and acquirers of corporations the issue of firm valuation is fundamental to much of the theory of corporate finance what determines the risk of the firm how the rate of return required by investors may be inferred from capital market data the influence of financing policy on firm value and other issues of central concern to the theory of financial management this almost total neglect of firm valuation is attributable perhaps to the overwhelming influence of the research programme initiated by the development of the capital asset pricing model only three years after the publication of the above mentioned paper by miller and modigliani in its primary form the capital asset pricing model is a statement about the equilibrium rates of return on securities rather than about the equilibrium values of securities it is straightforward to transform the model into a statement about the dependence of current equilibrium values upon an exogenously specified distribution of end of period values however in this form the model is inherently unsatisfactory since it fails to take account of the fact that in reality the distribution of end of period firm values is not exogenously given but is determined as part of a subsequent capital market equilibrium attempts to iterate the single period capital asset pricing model over several periods in order to avoid the need to take the distribution future security values as exogenous have been unsuccessful for the most part since not being able to derive they have been forced to assume both the requisite normality of the distribution of subsequent security prices and the legitimacy of ignoring endogenously determined shifts in the individual investor s investment

asset substitution and structured financing this article shows how structured financing can be used to solve the asset substitution problem in a dynamic setting structuring induces the firm s owner to optimally choose the first best operating strategy even though the owner s value function might be locally convex concave which would ordinarily lead to overinvestment underinvestment in risky projects this result is demonstrated in two different continuous time settings one that is based on the risk shifting framework of leland 1998 and one that generalizes the scaled return model of green 1984 it is shown that the contractual nature of the structuring is a key determinant of the issuing firm s dynamic asset volatility furthermore unlike nonstructured financing the default conversion probability of a structured debt security may be increasing decreasing in the firm s total assets structured securities are therefore hedge assets which potentially explains the popularity of structured securities among investors and third party issuers

credit market frictions and capital structure dynamics we study the implications of credit market frictions for the dynamics of corporate capital structure and the risk of default of corporations to do so we develop a dynamic capital structure model in which firms face uncertainty regarding their ability to raise funds in credit markets and have to search for investors when seeking to adjust their capital structure we provide a general analysis of shareholders dynamic financing and default decisions show when markov perfect equilibria in financing and default barrier strategies exist and when uniqueness can be achieved we then use the model to generate a number of novel testable implications relating credit market frictions to target leverage the pace and size of capital structure changes creditor turnover and the likelihood of default c 2014 elsevier inc all rights reserved

the interaction of debt financing cash grants and the optimal investment policy under uncertainty abstract significant progress has been made toward understanding a levered firm s optimal investment policy under uncertainty to date however not much work has concentrated on the time scale trade off and collectively held real options we employ a game theoretic real option model between a firm and a government to analyze the effect of uncertainty and investment stimulus in the form of cash grants on optimal investment timing financing and investment scaling we find that the jointly held real option between the firm and the government leads to underinvestment regardless of whether the firm has the possibility to issue debt subsidies however reduce the level of underinvestment notably the results indicate that even though levered firms receive less support they invest more than unlevered firms this challenges recent findings that a firm s optimal investment level is not affected by the way it finances a project similarly we find that for realistic parameter constellations the levered firm s optimal investment threshold can be higher than that of its unlevered counterpart this indicates that the availability of tax shield benefits does not necessarily serve as an incentive to invest earlier finally we show that the effect of cash flow uncertainty on the equilibrium level of grants is ambiguous and triggers the switch from a subsidy to non subsidy regime

measuring the agency cost of debt we adapt a contingent claims model of the firm to reflect the incentive effects of the capital structure and thereby to measure the agency costs of debt an underlying model of the firm and the stochastic features of its product market are analyzed and an optimal operating policy is chosen we identify the change in operating policy created by leverage and value this change the model determines the value of the firm and its associated liabilities incorporating the agency consequences of debt the optimal capital structure for a firm is now widely regarded to be determined by a broad range of factors including a mix of tax effects the various agency problems associated with different securities and the various costs of issuing securities including the costs created by adverse selection while the existence of a theoretical optimum has been demonstrated in a variety of papers a less explored area has been the construction of detailed models that enable us to measure each of the relevant factors for a particular company and thereby to determine the actual optimal mix for that firm this gap in our understanding is particularly glaring in the case of agency costs in order to allow a careful modelling of strategic relations the parameters of most agency models are either so simplified that it is impossible to associate them with measurable parameters of a real world case or else the models simply abstract from certain critical factors such as a robust measure of price risk that must be incorporated into any real application for example although we now understand that sinking funds dividend restrictions and other bond covenants help to resolve the conflict of interest between bondholders and equity we do not yet have much in the way of models with which to determine the optimal parameters of these very covenants contingent claims models can provide a consistent framework for multiperiod valuation that properly accounts for risk but they usually abstract from the agency factors entering capital structure decisions when using a contingent claims model to value a firm s securities it is common to take the value of the firm itself as governed by an exogenously defined stochastic process the value of the firm s securities are then derived from this underlying value and as merton 1974 points out in his paper on the pricing of risky debt the modigliani miller theorem obtains so that the value of the firm is independent of the value and the type of debt in order to apply the contingent claims techniques to a setting in which agency problems are central some adaptation is necessary in this paper we

remittances finance and growth does financial development foster the impact of remittances on economic growth abstract there is no consensus in the literature regarding the long run impact of remittances on economic growth previous studies have shown that it might be related to financial development in the transfer receiving country but the direction of the link remained unclear i contribute to this literature by using a newly created index of overall financial development and two different estimation methods i measure the importance of remittances given financial development for economic growth in developing countries as there is no widely accepted measure of financial sector development i estimate an index of overall financial conditions it is created by means of an unobserved components model and used to determine the relevance of the financial sector as a transmission channel for remittances to affect economic growth i show that the more financially developed a country is the smaller the impact of remittances on economic growth remittances can foster growth but the effect is significant only at low levels of financial development this is in line with previous studies which found remittances and financial development to be substitutes however the interaction between the two factors becomes weaker once size depth and efficiency of the financial sector are taken into account my results suggest that while attracting migrants transfers can have important short run poverty alleviating advantages in the long run it might be more beneficial for governments to foster financial sector development

how big is the debt overhang problem abstract i re examine the debt overhang problem where the flexible investment level rather than the irreversible decision whether or not to operate is used to measure the underinvestment caused by debt financing i measure a large overhang cost with long term debt or short term debt as is standard underinvestment with long term debt is more severe when investment opportunities are poor and is mitigated as opportunities improve in contrast underinvestment with short term debt remains significant even when investment opportunities are good firms lever up as opportunities improve to take advantage of tax shields so that equity claimants still face the incentive to underinvest

irreversible investment managerial discretion and optimal capital structure abstract we explore the significance of employee compensation and alternative reservation income on investment timing endogenous default yield spreads and capital structure in a real options setting a manager s incentive to under over invest in a project is associated to labor income he has to forego in order to work on the project the manager s salary his stake on the project s equity capital and his subsequent income should he decide to terminate operations we find that the optimal level of coupon payments decreases with managerial salary and ownership stake while it is increasing in the manager s reservation income yield spreads optimal leverage ratios are increasing decreasing in the manager s salary and ownership stake while they are decreasing increasing in the manager s reservation income exploring agency costs of debt as deviations from a value maximizing investment policy we document a u shaped relationship between agency costs of debt and the managerial compensation parameters the manager s reservation income salary and ownership share

continuous time methods in finance a review and an assessment i survey and assess the development of continuous time methods in finance during the last 30 years the subperiod 1969 to 1980 saw a dizzying pace of development with seminal ideas in derivatives securities pricing term structure theory asset pricing and optimal consumption and portfolio choices during the period 1981 to 1999 the theory has been extended and modified to better explain empirical regularities in various subfields of finance this latter subperiod has seen significant progress in econometric theory computational and estimation methods to test and implement continuous time models capital market frictions and bargaining issues are being increasingly incorporated in continuous time theory the roots of modern continuous time methods in finance can be traced back to the seminal contributions of merton 1969 1971 1973b in the late 1960s and early 1970s merton 1969 pioneered the use of continuous time modeling in financial economics by formulating the intertemporal consumption and portfolio choice problem of an investor in a stochastic dynamic programming setting merton 1973b also showed how such a framework can be used to develop equilibrium asset pricing implications thereby significantly extending the asset pricing theory to richer dynamic settings and expanding the scope of applications of continuous time methods to study problems in financial economics 1 within a span of about 30 years from the publication of merton s inf luential papers continuous time methods have become an integral part of financial economics indeed in certain core areas in finance such as e g asset pricing derivatives valuation term structure theory and portfolio selection continuoustime methods have proved to be the most attractive way to conduct research and gain economic intuition the continuous time approach in these areas has produced models with a rich variety of testable implications the econometric theory for testing continuous time models has made rapid strides in the last decade and has thus kept pace with the impressive progress on the theoretical front one hopes that the actual empirical investigations and estimation using the new procedures will follow suit soon

a game options approach to the investment problem with convertible debt financing we consider a firm that operates a single plant and has an expansion option to invest in a new plant with convertible debt financing this conversion feature introduces another complication not only because of the added conversion timing problem by the bond holder but also because the equity holder needs to take future conversion into account when evaluating her expansion financing decision we have two main objectives here we use game options techniques to analyze optimal strategies involved in this convertible debt financed expansion problem the first goal is to provide a comprehensive framework and procedure for solving the problem in a mathematically tractable way secondly we illustrate our solution method through a concrete example with economic analysis this includes a comparison with straight bond financing and comparative statics with respect to price volatility and conversion ratio in this regard we attempt to clarify how the conversion feature affects the equity holder s investment decisions throughout the paper we study expansion options by viewing a firm s existing operation bankruptcy threat conversion decisions and financing decisions all together

real flexibility and financial structure an empirical analysis i examine the empirical relation between real flexibility and financial structure i test whether real flexibility increases debt capacity by lowering default risk and making assets more marketable or decreases debt capacity by facilitating risk shifting and asset substitution i measure real flexibility as the sensitivity of marginal production and investment decisions to variations in the economic environment i find that financial leverage is negatively related to production flexibility but positively related to investment flexibility this split in results suggests that although asset substitution facilitated by investment flexibility can be prevented contractually risk shifting facilitated by production flexibility is intractable copyright 2003 oxford university press

interactions of corporate financing and investment decisions a dynamic framework this article analyzes the interaction between a firm s dynamic investment operating and financing decisions in a model with operating adjustment and recapitalization costs using numerical analysis we solve the model for cases that highlight interaction effects we find that higher production flexibility due to lower costs of shutting down and reopening a production facility enhances the firm s debt capacity thereby increasing the net tax shield value of debt financing while higher financial flexibility resulting from lower recapitalization costs has a similar effect production flexibility and financial flexibility are to some extent substitutes we find that the impact of debt financing on the firm s investment and operating decisions is economically insignificant

dynamic recapitalization policies and the role of call premia and issue discounts in a dynamic framework the advantage of leverage depends upon the firm s recapitalization policy we show that if bonds are callable at par then equityholders have an incentive to recapitalize too early call premia and issue discounts however mitigate the agency problem of early recapitalization the model provides the optimal call premium and issue discount as a function of firm specific characteristics an analysis of a bond sample supports the model s prediction that the optimal call premium is positively related to firm risk

the impact of debt financing on entry and exit in a duopoly this article investigates the interaction between market entry company foreclosure and capital structure in a duopoly we find that the order in which firms foreclose is determined not only by differences in firm specific factors but also by common economic factors such as the interest rate and the market profit volatility we extend the exit model by allowing financially distressed firms to renegotiate their debt contracts through a one off debt exchange offer we find that firms with high bankruptcy costs or with prospects of profit improvement can get bigger reductions on their debt repayments investigating market entry we find that financial vulnerability of the incumbent induces earlier entry article published by oxford university press on behalf of the society for financial studies in its journal the review of financial studies

multinational capital structure and financial flexibility abstract we address multinational capital structure decisions when firms have varying degrees of financial flexibility for shifting income and or tax shields between subsidiaries we find 1 firms can use leverage to dramatically reduce negative valuation effects from operating in a high tax country 2 financial flexibility is a key determinant of optimal capital structure acting as both a substitute and a complement for leverage 3 multinational firms derive a synergistic effect from financial flexibility which can enhance their value beyond that for a single country firm from a low tax jurisdiction and 4 optimal capital structure typically differs substantially across subsidiaries with each having positions in multiple currencies

optimal priority structure capital structure and investment we study the interaction between financing and investment decisions in a dynamic model where the firm has multiple debt issues and equityholders choose the timing of investment jointly optimal capital and priority structures can virtually eliminate investment distortions because debt priority serves as a dynamically optimal contract examining the relative efficiency of priority rules observed in practice we develop several predictions about how firms adjust their priority structure in response to changes in leverage credit conditions and firm fundamentals notably financially unconstrained firms with few growth opportunities prefer senior debt while financially constrained firms with or without growth opportunities prefer junior debt moreover lower rated firms are predicted to spread priority across debt classes finally our analysis has a number of important implications for empirical capital structure research including the relations between market leverage book leverage and credit spreads and tobin s q the influence of firm fundamentals on the agency cost of debt and the conservative debt policy puzzle the author 2011 published by oxford university press on behalf of the society for financial studies all rights reserved for permissions please e mail journals permissions oup com oxford university press

the imf and the emerging markets a reappraisal of the central banking model abstract country level appraisals of international monetary fund imf programs have eclipsed concerns with the global role of the organization this reconsideration of the early central banking analogy is prompted by the emerging markets phenomenon drawing on the banking literature the role of national reserve holdings in the context of adjustable exchange rates is addressed the central bank parallel suggests that reserves complement the growth of obligations to international capital markets and a public goods case is made for imf involvement in this connection the prudential regulation aspect of central banking is also explored for its insights into the evolution of the fund in the context of open capital markets

capital structure debt maturity and stochastic interest rates this article develops a model in which optimal capital structure and debt maturity are jointly determined in a stochastic interest rate environment the model yields leverage ratios that are consistent in spirit with empirical observations the optimal maturity and credit spread of an optimally issued debt are found to be smaller than observed values the long run mean of the interest rate is found to be a key variable in determining optimal capital structure and debt maturity furthermore the interest rate volatility and the correlation between the interest rate and the firm s asset value play important roles in determining debt maturity

strategic debt service and investment decisions firms alter investing decisions when there is debt in the capital structure security design features can exacerbate the situation this article studies how strategic debt service may affect investment distortions resulting from debt financing in a dynamic framework when the production decision involves an expansion option the shareholders option to strategically default on the outstanding debt eliminates bankruptcy costs but in contrast to previous literature where production decisions are fixed leads to suboptimal investing decisions this is due to higher wealth transfers from shareholders to debt holders upon exercise of the growth option strategic debt service therefore may reduce the value of the firm the setting of an endogenous production set offers a potential explanation for empirical observations of wide credit spreads and low leverage

cash flow shortage as an endogenous bankruptcy reason abstract this paper develops a simple model for a leveraged firm and endogenizes the firm s bankruptcy point by assuming that equity issuance is costly equity issuance costs reflect the difficulties in issuing new equity for firms that are close to financial distress the resulting model captures cash flow shortage as a reason to go bankrupt though the equity value is positive i analyze the optimal bankruptcy point as well as corporate bond prices and yield spreads for various levels of equity issuance costs in order to study the impact of different liquidity constraints finally i discuss the consequences on optimal capital structure

dynamic investment and capital structure under manager shareholder conflict abstract this paper investigates the interactions between the investment and financing decisions of a firm under manager shareholder conflicts arising from asymmetric information in particular we extend the manager shareholder conflict problem in a real options model by incorporating debt financing we show that manager shareholder conflicts over investment policy increase not only the investment and default triggers but also coupon payments which lead to a decrease in the equity value moreover given the presence of manager shareholder conflicts debt financing increases investment and decreases total social welfare as a result there is a trade off between the efficiency of investment and total social welfare with debt financing these results fit well with the findings of previous empirical work in this area

horses and rabbits trade off theory and optimal capital structure this paper examines optimal capital structure choice using a dynamic capital structure model that is calibrated to reflect actual firm characteristics the model uses contingent claim methods to value interest tax shields allows for reorganization in bankruptcy and maintains a long run target debt to total capital ratio by refinancing maturing debt using this model we calculate optimal capital structures in a realistic representation of the tra ditional trade off model in contrast to previous research the calculated optimal capital structures do not imply that firms tend to use too little leverage in practice we also esti mate the costs borne by a firm whose capital structure deviates from its optimal target debt to total capital ratio the costs of moderate deviations are relatively small suggesting that a policy of adjusting leverage infrequently is likely to be reasonable for many firms

taxation agency conflicts and the choice between callable and convertible debt abstract we analyze debt choice in light of taxes and moral hazard the model features an infinite sequence of nonzero sum stochastic differential games between equity and debt closed form expressions are derived for all contingent claims if equity can increase volatility without reducing asset drift callable bonds with call premia are optimal although callable bonds induce risk shifting call premia precommit equity to less frequent restructuring and are tax advantaged convertible bonds mitigate risk shifting but only induce hedging if assets are far from the default threshold convertibles are optimal only if risk shifting reduces asset drift sufficiently

investment timing asymmetric information and audit structure a real options framework abstract this paper examines investment timing by the manager in a decentralized firm in the presence of asymmetric information in particular we incorporate an audit technology in the agency model developed by grenadier and wang 2005 investment timing agency and information journal of financial economics 75 493 533 the implied investment trigger in the agency problem with auditing is larger than in the full information problem and smaller than in the agency problem without auditing nevertheless the audit technology does not necessarily reduce inefficiency in the total social welfare

interactions of corporate financing and investment decisions the effects of agency conflicts abstract we examine interactions between flexible financing and investment decisions in a model with stockholder bondholder conflicts over investment policy we find that financial flexibility encourages the choice of short term debt thereby dramatically reducing the agency costs of under and overinvestment however the reduction in agency costs may not encourage the firm to increase leverage since the firm s initial debt level choice depends on the type of growth options in its investment opportunity set the model has a number of testable predictions for the joint choice of leverage and maturity and how these choices interact with a firm s growth opportunities