Ilya A. Strebulaev

Structural models of credit risk are useful: evidence from hedge ratios on corporate bonds.

Structural models of credit risk provide poor predictions of bond prices. We show that, despite this, they provide quite accurate predictions of the sensitivity of corporate bond returns to changes in the value of equity (hedge ratios). This is important since it suggests that the poor performance of structural models may have more to do with the influence of non-credit factors rather than their failure to capture the credit exposure of corporate debt. The main result of this paper is that even the simplest of the structural models [Merton, R., 1974. On the pricing of corporate debt: the risk structure of interest rates. Journal of Finance 29, 449-470] produces hedge ratios that are not rejected in time-series tests. However, we find that the Merton model (with or without stochastic interest rates) does not capture the interest rate sensitivity of corporate debt, which is substantially lower than would be expected from conventional duration measures. The paper also shows that corporate bond prices are related to a number of market-wide factors such as the Fama-French SMB (small minus big) factor in a way that is not predicted by structural models.

The Aggregate Dynamics of Capital Structure and Macroeconomic Risk

We study the impact of time-varying macroeconomic conditions on optimal dynamic capital structure for a cross-section of firms. Our structural-equilibrium framework embeds a contingent-claim corporate financing model within a consumption-based asset-pricing model. We investigate the effect of macroeconomic conditions on asset valuation and optimal corporate policies, and of preferences on capital structure. While capital structure is pro-cyclical at dates when firms re-lever, it is counter-cyclical in aggregate dynamics, consistent with empirical evidence. We also find that financially constrained firms choose more pro-cyclical policies and that leverage accounts for most of the macroeconomic risk relevant for predicting defaults, but is a poor measure of how preferences impact capital structure. The Author 2010. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org., Oxford University Press.

Dynamic Models and Structural Estimation in Corporate Finance

We review the last two decades of research in dynamic corporate finance, focusing on capital structure and the financing of investment. We first cover continuous time contingent claims models, starting with real options models, and working through static and dynamic capital structure models. We then move on to corporate financing models based on discrete-time dynamic investment problems. We cover the basic model with no financing, as well as more elaborate models that include features such as costly external finance, cash holding, and both safe and risky debt. For all the models, we offer a minimalist, simplified presentation with a great deal of intuition. Throughout, we show how these models can answer questions concerning the effects of financial constraints on investment, the level of corporate leverage, the speed of adjustment of leverage to its target, and market timing, among others. Finally, we review and explain structural estimation of corporate finance models.

Firm Size and Capital Structure

Firm size has been empirically found to be strongly positively related to capital structure. This paper investigates whether a dynamic capital structure model can explain the cross-sectional size-leverage relationship. The driving force that we consider is the presence of fixed costs of external financing that lead to infrequent restructuring and create a wedge between small and large firms. We find four firm-size effects on leverage. Small firms choose higher leverage at the moment of refinancing to compensate for less frequent rebalancings. Their longer waiting times between refinancings lead to lower levels of leverage at the end of restructuring periods. Within one refinancing cycle the intertemporal relationship between leverage and firm size is negative. Finally, there is a mass of firms opting for no leverage. The analysis of dynamic economy demonstrates that in cross-section the relationship between leverage and size is positive and thus fixed costs of financing contribute to the explanation of the stylized size-leverage relationship. However, the relationship changes sign when we control for the presence of unlevered firms.

Government Policy and Ownership of Equity Securities

Since World War II, direct stock ownership by households across the globe has largely been replaced by indirect stock ownership by financial institutions. We argue that tax and retirement policies are among the factors behind these changes. We develop empirical measures of two tax incentives of holding stocks inside tax-deferred plans, tax-free investment income and the smoothing benefit. Using long time-series from eight countries, we show that the fraction of household ownership decreases with these measures of the tax benefits. This finding contributes to policy debates on effective taxation and to financial economics research on the long-term effects of taxation on corporate finance and asset prices.

Macroeconomic effects of corporate default crisis: A long-term perspective

Using an extensive new data set on corporate bond defaults in the U.S. from 1866 to 2010, we study the macroeconomic effects of bond market crises and contrast them with those resulting from banking crises. During the past 150 years, the U.S. has experienced many severe corporate default crises in which 20 to 50 percent of all corporate bonds defaulted. Although the total par amount of corporate bonds has often rivaled the amount of bank loans outstanding, we find that corporate default crises have far fewer real effects than do banking crises. These results provide empirical support for current theories that emphasize the unique role that banks and the credit and collateral channels play in amplifying macroeconomic shocks.

Beyond Random Assignment: Credible Inference of Causal Effects in Dynamic Economies

Random assignment is insufficient for measured treatment responses to recover causal effects (comparative statics) in dynamic economies. We characterize analytically bias probabilities and magnitudes. If the policy variable is binary there is attenuation bias. With more than two policy states, treatment responses can undershoot, overshoot, or have incorrect signs. Under permanent random assignment, treatment responses overshoot (have incorrect signs) for realized changes opposite in sign to (small relative to) expected changes. We derive necessary and sufficient conditions, beyond random assignment, for correct inference of causal effects: martingale policy variable. Infinitesimal transition rates are only sufficient absent fixed costs. Stochastic monotonicity is sufficient for correct sign inference. If these conditions are not met, we show how treatment responses can nevertheless be corrected and mapped to causal effects or extrapolated to forecast responses to future policy changes within or across policy generating processes.We argue exogenous random treatment is insufficient for valid inference regarding the sign and magnitude of causal effects in dynamic environments. In such settings, treatment responses must be understood as contingent upon the typically unmodeled policy generating process. With binary assignment, this results in quantitatively significant attenuation bias. With more than two policy states, treatment responses can be biased downward, upward, or have the wrong sign. Further, it is not only generally invalid to extrapolate elasticities across policy processes, as argued by Lucas (1976), but also to extrapolate within the same policy process. We derive auxiliary assumptions beyond exogeneity for valid inference in dynamic settings. If all possible policy transitions are rare events, treatment responses approximate causal effects. However, reliance on rare events is overly-restrictive as the necessary and sufficient conditions for equality of treatment responses and causal effects is that policy variable changes have mean zero. If these conditions are not met, we show how treatment responses can nevertheless be corrected and mapped back to causal effects or extrapolated to forecast responses to future policy changes.

Dynamic Information Asymmetry, Financing, and Investment Decisions

We study the optimal timing of security issuance to finance a new project when the firms assets in place have unobservable quality. Stochastic cash flows generated by assets in place reveal information about their quality and simultaneously reduce the required outside funding. A high-quality firm optimally delays issuance unless its accumulated cash or the market belief about its quality is sufficiently high. A low-quality firm does the same and, additionally, issues if market belief and accumulated cash are sufficiently low. Under stated restrictions, the renegotiation-proof optimal security pays outside investors in full before paying anything to original shareholders.

The Economic Impact of Venture Capital: Evidence from Public Companies

Over the past 30 years, venture capital has become a dominant force in the financing of innovative American companies. From Google to Intel to FedEx, companies supported by venture capital have profoundly changed the U.S. economy. Despite the young age of the venture capital industry, public companies with venture capital backing employ four million people and account for one-fifth of the market capitalization and 44% of the research and development spending of U.S. public companies. From research and development to employment to simple revenue, the companies funded by venture capital are a major part of the U.S. economy.

An Empirical Target Zone Model of Dynamic Capital Structure

We develop and estimate a general (S, s) model of capital structure to investigate the relation between target leverage, refinancing thresholds, and firm characteristics in a dynamic environment. We find that firms’ target leverage is pro-cyclical, consistent with dynamic capital structure models, but in contrast to traditional regression results. The target leverage zone, in which companies optimally allow leverage to float, widens during recessions. Most of the time series variation in capital structure policy variables is due to aggregate macroeconomic factors, rather than changes in firm-specific variables.