We empirically document and theoretically investigate why non-dilutive CoCos are prevalent, even though advocates of CoCos suggest such securities should be dilutive to reduce bank risk-taking. In an agency model with two subsequent moral hazards, we show that while dilutive CoCos deter ex-ante risk-taking and prevent a bank from being undercapitalized, penalizing existing shareholders with dilution when the bank is already undercapitalized leads to risk shifting. CoCos’ designs and risk implications depend on banks’ equity capitalization, with nondilutive CoCos particularly attractive to capital-constrained banks, because such securities can maximize the banks’ financing capacity by tackling only the ex-post risk shifting.

There have been several cases in recent years where credit default swap (CDS) buyers and sellers intervene in the restructuring of a distressed firm. We show theoretically that this can increase firm value. Intervention by CDS buyers solves the commitment problem between equity and debt holders but increases the probability of inefficient liquidation. Intervention by CDS sellers reduces the issue of excessive liquidation while keeping the benefits of CDS buyer intervention. Having both types of intervention decouples the commitment problem from the liquidation problem. Under certain assumptions, the so-called empty creditor problem can be solved, and firm value reaches first best. This paper was accepted by Lukas Schmid, finance. Supplemental Material: The internet appendix is available at https://doi.org/10.1287/mnsc.2023.4717 .

If firms can issue debt only at discrete dates, debt maturity is an effective device against the commitment problem on debt and investment policies. With shorter maturities, debt dynamics are less persistent and more valuable because upward leverage adjustments are faster and long-run leverage lower. Debt maturities that are relatively shorter than asset maturities increase marginal q, and reduce underinvestment. A decomposition of the credit spread consistent with equilibrium shows that the component due to the commitment problem on future debt issuances is sizeable when leverage and default risk are low, and is lower for shorter maturity. JEL Classification: G12, G31, G32, E22.

We show that a dynamic model of investment and capital structure choices, where the firm faces real and financial frictions, can generate option prices and implied volatilities that are in line with those of the average optionable stock. As the balance between the fundamental economic forces that are responsible for the way options are priced is state-dependent, the model is also able to generate a wide cross-sectional dispersion in implied volatility surfaces that matches what we observe in the data. JEL Classifications: G12, G32 We thank seminar participants at Washington University in St.Luois for useful comments. Scarman Road, Coventry, UK CV4 7AL. E-mail: andrea.gamba@wbs.ac.uk 800 West Campbell Road, Richardson, Texas 75080. E-mail: asaretto@utdallas.edu

In a dynamic setup, the value of a capital structure policy for a firm depends on shareholders’ commitment. We analyze whether debt covenants can be com- mitment devices and their disciplinary effect on firm policies. While renegotiation following covenant violations allows for debt holders’ control and improves the ex post firm value, it weakens commitment on leverage policies and leads to ex ante firm value losses similar to those under no covenants, as well as a rigid debt issuance policy which is unable to respond to productivity shocks. Therefore, frictions that hinder ex post renegotiation are crucial for covenants to be commitment devices. Under commitment, covenants that discipline the leverage improve firm value the most because they restore the flexibility of debt policy. Instead, covenants de- signed to deliver ex post debt protections, like debt and asset sweeps, are less efficient, as they do not affect the dynamics of leverage. An efficient covenant also has a positive effect on investments.

Current corporate risk management theories predict that young firms should hedge more than the established ones. However, the claim is not supported by empirical observations, which also present mixed evidence on whether hedging creates value. This paper attempts to address this puzzle by including model uncertainty as part of risk management process. We develop a dynamic model in which agents learn about a firm’s hedgeability, gauged by the correlation between its operating cash flow and underlying asset of hedging instruments, while weighing the costs and benefits of different risk management tools. The model predicts that resolving model uncertainty accelerates the process of building up hedging positions, but this is not necessarily accompanied with firm value creation. We conclude that dynamic information acquisition is an important determinant of corporate risk management.

We consider a dynamic model of investment in which a firm can hold inventory to mitigate the price risk of an input commodity. Our model predicts that inventory allows to hedge against net worth risk by smoothing investment in capital, irrespective of the level of current net worth. Savings enhance the operational hedge offered by inventory, because they better conserve net worth when the commodity price is low. These predictions are confirmed in a sample of U.S. manufacturing corporations. We find that the empirical sensitivity of inventory investment to price changes is positive for any level of the firm’s net worth. While savings and inventory are both positively related to financing constraints and cash flow risk, investment is more sensitive to inventory.

There have been several cases in recent years where credit default swap (CDS) buyers and sellers intervene in the restructuring of a distressed firm. We show theoretically that this can increase firm value. Intervention by CDS buyers solves the commitment problem between equity- and debt-holders but increases the probability of inefficient liquidation. Intervention by CDS sellers reduces the issue of excessive liquidation while keeping the benefits of CDS buyer intervention. Having both types of intervention decouples the commitment problem from the liquidation problem. Under certain assumptions, the so-called empty creditor problem can be solved and firm value reaches first-best.

Lack of shareholders' commitment about debt and investment policies increases the cost of debt by a quantity that we refer to as the agency (credit) spread. The agency spread increases with the number of periods for which debt holders are exposed to policies that decrease the value of debt: from 10 basis points or equivalently 5.4% of the average credit spread at one year horizon to 44 basis points and 27%, respectively, at fifty years horizon. At short horizons, small firms with valuable growth options have larger agency spreads. At longer horizons, conversion of options into assets in place and the leverage ratchet effect invert the relationship and deliver higher agency costs for large firms, delivering a non-trivial term structure of the agency credit spread.

We examine the effect of introducing credit default swaps (CDSs) on firm value. Our model allows for dynamic investment and financing, and bondholders can trade in the CDS market. The model incorporates both negative and positive effects of CDSs. CDS markets lead to more liquidations, but they also reduce the probability of costly debt renegotiation and reduce costly equity financing. After calibrating the model, we find that firm value increases by 2.9% on average with the introduction of a CDS market. Firms also invest more and increase leverage. The effect on firm value is strongest for small, financially constrained, and low productivity firms.

We study optimal bank regulation in an economy with aggregate uncertainty. Bank liabilities are used as “money” and hence earn lower returns than equity. In laissez faire equilibrium, banks maximize market value, trading off the funding advantage of debt against the risk of costly default. The capital structure is not socially optimal because external costs of distress are not internalized by the banks. The constrained efficient allocation is characterized as the solution to a planner’s problem. Efficient regulation is procyclical, but countercyclical relative to laissez faire. We show that simple leverage constraints can get the decentralized economy close to the constrained efficient outcome.

We calibrate a dynamic model of credit risk and analyze the relation between growth options and credit spreads. Our model features real and financing frictions, a technology with decreasing returns to scale, and endogenous investment options driven by both systematic and idiosyncratic shocks. We find a negative relation between credit spreads and growth options after controlling for determinants of credit risk. This negative relation is a result of the current decision to invest and the associated change in leverage, which, in the presence of external financing needs and financing frictions, increase credit spreads while reducing the value of future investments. We do not find evidence that growth options accrue value in response to systematic risk, thus increasing credit risk premia. This paper was accepted by Karl Diether, finance.

We develop and test an agency-based contingent claims model that features debt renegotiation for cross-sectional stock returns. Our model performs well for cross-sectional returns of portfolios formed on financial leverage, book-to-market equity, and asset growth portfolios, because the time-varying stock-cash flow sensitivity we estimate in a closed-form solution captures default risk over the business cycle. Moreover, our structural estimation overcomes the difficulty of finding empirical proxies for unobservable bargaining power at debt renegotiation and provides the first direct evidence that the bargaining power helps alleviate equity risk, particularly during recessions when default probabilities are high.

We analyze the relation between credit risk and growth options in a dynamic structural model of the firm. Our model features real and financing frictions that make investments relevant for capital structure decisions, and counter-cyclical risk premia that determine investment decisions. We find that growth options are negatively related to credit risk, as the conditions that allow such growth options to become valuable are also related to the firm’s ability to repay debt obligations.

Creditors monitor their borrowers less vigilantly and become tougher bargaining parties in debt renegotiations when they can hedge their exposure using credit default swaps (CDS). Thus, the inception of CDS trading on the debt of a firm can affect its financing abilities and risk management policies. We find that CDS firms hold more cash after CDS trading is introduced – cash that might be partly financed by new debt issues. These increased cash holdings are more pronounced for CDS firms that do not pay dividends, own more intangible assets, and have higher marginal value of liquidity. For CDS firms with higher cash flow volatility, these increased cash holdings do not entail higher leverage. Overall, although trading in CDS facilitates debt financing, it also induces CDS-referenced firms to adopt more conservative liquidity policies. ∗For helpful comments on previous drafts of this paper, we thank an anonymous referee, Lauren Cohen, Miguel Ferreira, Andrea Gamba, Robin Greenwood, Jarrad Harford, Victoria Ivashina, Andrew Karolyi, Beni Lauterbach, Kai Li, Chen Lin, Tse-chun Lin, Ron Masulis, Florian Nagler, Joshua Pollet, Henri Servaes, Laura Starks, René Stulz, Neng Wang, Toni Whited, Ashraf Al Zaman, and seminar and conference participants at the University of Hong Kong, the University of Warwick, the University of Münster, University of Reading, University of Manchester, the 2012 NTU International Conference on Finance, the 2012 SFM Conference at the National Sun Yat-sen University, the 2013 European Finance Association Meetings, the 2014 Jerusalem Finance Conference, the 2014 Annual Global Finance Conference, the 4th International Conference of F.E.B.S. at the University of Surrey, the 2014 Risk Management Institute Annual Conference at National University of Singapore, and the 2014 Northern Finance Association Annual Meetings. Credit Default Swaps, Debt Financing and Corporate Liquidity Management

This paper studies the quantitative impact of microprudential bank regulations on bank lending and value metrics of efficiency and welfare in a dynamic model of banks that are financed by debt and equity, undertake maturity transformation, are exposed to credit and liquidity risks, and face financing frictions. We show that (1) there exists an inverted U-shaped relationship between bank lending, welfare, and capital requirements, (2) liquidity requirements unambiguously reduce lending, efficiency, and welfare, and (3) resolution policies contingent on observed capital, such as prompt corrective action, dominate in efficiency and welfare terms (noncontingent) capital and liquidity requirements.

We analyze the value created by a dynamic integrated risk management strategy involving liquidity management, derivatives hedging, and operating flexibility, in the presence of several frictions. We show that liquidity serves a critical and distinct role in risk management, justifying high levels of cash. We find that the marginal value associated with derivatives hedging is likely to be low, though we explain why some empirical studies find a higher value. We explore the complex interactions between operating flexibility and financial risk management, finding that substitution effects are nonmonotonic and are affected by operating leverage, the nature of operating flexibility, and the effectiveness of the hedging instrument. This paper was accepted by Jerome Detemple, finance.