Equilibrium Asset Pricing with Leverage and Default∗

We develop a general equilibrium model linking the pricing of stocks and corporate bonds to endogenous movements in corporate leverage and aggregate volatility. The model has heterogeneous firms making optimal investment and financing decisions and connects fluctuations in macroeconomic quantities and asset prices to movements in the cross-section of firms. Empirically plausible movements in leverage produce realistic asset return dynamics. Countercyclical leverage drives predictable variation in risk premia, and debt-financed growth generates a high value premium. Endogenous default produces countercyclical aggregate volatility and credit spread movements that are propagated to the real economy through their effects on investment and output. ∗We are grateful to comments from Andy Abel, Hui Chen, Urban Jermann, Aubhik Kahn, Dmitry Livdan, Neng Wang and participants at seminars in Calgary, Carnegie-Mellon, Duke, Wharton, NY Fed, NYU, Richmond Fed, ECB, UBC, UCLA, and Imperial College, as well as the following conferences: AFA, SED, Minnesota Macro Week, NBER Capital Markets, NYU Five Star, Rimini Macro-Finance, UCSB-LAEF, Venice C.R.E.D.I.T, and ESSFM Gerzensee. All errors remain our own. †The Wharton School, University of Pennsylvania. Email: [email protected] ‡The Fuqua School of Business, Duke University. Email: [email protected]