Learning and leverage cycles in general equilibrium: theory and evidence

Hennessy, C and Radnaev, B (2018) Learning and leverage cycles in general equilibrium: theory and evidence. Review of Finance, 22 (1). pp. 311-335. ISSN 1572-3097


This article develops and empirically tests a tractable general equilibrium model of corporate financing and investment dynamics in a trade-off economy where heterogeneous firms face unobservable disaster risk and engage in rational Bayesian learning. The model sheds light on leverage cycles. During periods absent disasters: equity premia decrease; credit spreads decrease; expected loss-given-default increases; and leverage ratios increase. Time-since-prior-disaster is the key model conditioning variable. In response to a disaster, risk premia increase while firms sharply reduce labor, capital and leverage, with response size increasing in time-since-prior-disasters. Firms with high bankruptcy costs are most responsive to the time-since-disaster variable. Disaster responses are more pronounced than in an otherwise equivalent economy featuring observed disaster risk. Empirical tests of novel corporate finance predictions are conducted. Consistent with the model, we find empirically that leverage and investment are increasing in time-since-prior-recessions, with the effect more pronounced for firms with low recovery ratios.

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Item Type: Article
Subject Areas: Finance
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© 2016 European Finance Association

Date Deposited: 23 Feb 2017 14:04
Subjects: Capital theory
Last Modified: 14 Feb 2023 01:28
URI: https://lbsresearch.london.edu/id/eprint/612

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