Optimal capital structure, endogenous bankruptcy, and the term structure of credit spreads

Article Abstract:

This article examines the optimal capital structure of a firm that can choose both the amount and maturity of its debt. Bankruptcy is determined endogenously rather than by the imposition of a positive net worth condition or by a cash flow constraint. The results extend Leland's (1994a) closed-form results to a much richer class of possible debt structures and permit study of the optimal maturity of debt as well as the optimal amount of debt. The model predicts leverage, credit spreads, default rates, and writedowns, which accord quite closely with historical averages. While short term debt does not exploit tax benefits as completely as long term debt, it is more likely to provide incentive compatibility between debt holders and equity holders. Short term debt reduces or eliminates "asset substitution" agency costs. The tax advantage of debt must be balanced against bankruptcy and agency costs in determining the optimal maturity of the capital structure. The model predicts differently shaped term structures of credit spreads for different levels of risk. These term structures are similar to those found empirically by Sarig and Warga (1989). Our results have important implications for bond portfolio management. In general, Macaulay duration dramatically overstates true duration of risky debt, which may be negative for "junk" bonds. Furthermore, the "convexity" of bond prices can become "concavity." (Reprinted by permission of the publisher.)

Analysis, Debt financing (Corporations), Debt financing, Bankruptcy, Capital

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Option pricing and replication with transactions costs

Article Abstract:

The Black-Scholes arbitrage argument for option pricing is invalidated by transactions costs because infinite trading is implied by continuous revision, and discrete revision through use of Black-Scholes deltas results in errors which are correlated with the market and which do not approach zero with more frequent revision when transactions costs are included. A modified option replicating strategy depending on the size of transactions costs and the frequency of revision is developed in which hedging errors are not correlated with the market and approach zero with more frequent revision. Calculation of the transactions costs of option replication is permitted by the technique, and bounds on option prices are provided.

Research, Models, Investments, Hedging (Finance), Securities industry, Arbitrage

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Symposium on public policy issues in finance

Article Abstract:

The thesis of this symposium, organized by James Bicksler, was that while finance theory will surely inform practitioners, it seems appropriate to pay some attention to the opposite flow: practitioners can inform theory. Contributors include a distinguished group of practitioners with extensive backgrounds in economics, and economists with extensive public policy experience: Martin Feldstein, Robert Glauber, David Mullins, and Steven Wallman. Their topics range from privatizing social security, to managing market crashes, to the regulatory agency cost problem, to regulatory constraints in a technologically advanced world. (Reprinted by permission of the publisher.)

Financial Services, Finance and Insurance, Regulation, Licensing, and Inspection of Miscellaneous Commercial Sectors, Financial Regulation NEC, Conferences, meetings and seminars, Laws, regulations and rules, Financial services industry, Commercial law, Financial management, Public policy (Law)

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