This paper develops and analyzes a dynamic model of leverage, taking account of tax deductibility of interest payments and the endogenous expected cost of default. The interest rate on debt includes a premium to compensate lenders for expected losses in default. Lenders are unwilling to lend an amount that would trigger immediate default, which places a borrowing constraint on the firm. When th...

We analyze equilibrium leverage dynamics in a dynamic tradeoff model when the firm is unable to commit to a leverage policy ex ante. We develop a methodology to characterize equilibrium equity and debt prices in a general jump-diffusion framework, and apply our approach to the standard Leland (1998) setting. Absent commitment, the leverage ratchet effect (Admati et al. 2015) causes firms to tak...

Liquidity and Capital Structure* This paper solves for a firm's optimal cash holding policy within a continuous time, contingent claims framework that has been extended to incorporate most of the significant contracting frictions that have been identified in the corporate finance literature. Under the optimal policy the firm targets a level of cash holding that is a non-monotonic function of bu...

Financial frictions can reduce aggregate productivity, in particular when firms with high productivity cannot borrow against their profits. This paper investigates the quantitative importance of this form of borrowing constraint using a large panel of firms in Japan. The firms are young and unlisted, precisely the firms for which credit frictions are expected to be the most severe. In this data...

We review the theory of leverage developed in collateral equilibrium models with incomplete markets. We explain how leverage tends to boost asset prices, and create bubbles. We show how leverage can be endogenously determined in equilibrium, and how it depends on volatility. We describe the dynamic feedback properties of leverage, volatility, and asset prices, in what we call the Leverage Cycle...

We empirically investigate predictions from alternative intermediary asset pricing theories. The theories distinguish themselves in their use of intermediary equity or leverage as pricing factors or forecasting variables. We find strong support for a parsimonious dynamic pricing model based on broker-dealer leverage as the return forecasting variable and shocks to broker-dealer leverage as a cr...

We investigate intermediary asset pricing theories empirically and find strong support for intermediary book leverage as the relevant state variable. A parsimonious dynamic pricing model that uses detrended broker-dealer leverage as a price of risk variable, and innovations to broker-dealer leverage as pricing factor is shown to perform well in time series and cross sectional tests of a wide va...

Many stylized facts of leverage, trading, and asset prices follow from a frictionless general equilibrium model that features agents’ heterogeneity in endowments and habit preferences. Our model predicts that aggregate debt increases in good times when stock prices are high, return volatility is low, and levered agents enjoy a “consumption boom.” Our model is consistent with poorer agents borro...