Carlos González-Aguado

We explore the implications of aggregate uncertainty regarding the short-term interest rate in a dynamic model of firm financing with two key frictions: a moral hazard problem in the relationship between the firm and its outside financiers, and earnings retention as the only source of inside financing. Financial frictions make firms unable to adjust immediately to their target debt ratios after changes in the risk-free interest rate. We embed the financing model in a model of industry dynamics and analyze how changes in the interest rate affect firms in different stages of their lives. The model delivers patterns of leverage and survival rates (by age) consistent with empirical evidence. The predictions regarding the effect of a shift in the interest rate on credit risk show (i) a very different reaction of old and young firms, and (ii) an asymmetric response of all firms to increases and decreases in the short-term rate. These predictions suggest new lines of empirical research.

In recessions, the number of defaulting firms rises. On top of this, the average amount recovered on the bonds of defaulting firms tends to decrease. This paper proposes an econometric model in which this joint time-variation in default rates and recovery rate distributions is driven by an unobserved Markov chain, which we interpret as the "credit cycle". This model is shown to fit better than models in which this joint time-variation is driven by observed macroeconomic variables. We use the model to quantitatively assess the importance of allowing for systematic time-variation in recovery rates, which is often ignored in risk management and pricing models.