Finance Papers

Document Type

Working Paper

Date of this Version

3-2016

Publication Source

The Wharton School Research Paper

Issue

92

Abstract

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.

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Date Posted: 27 November 2017