Essays on dynamic economies with frictions.

Abstract

This dissertation consists of three essays. In the first essay, I develop and compare the implications of two closely related dynamic models of corporate capital structure to determine (i) whether costly capital adjustment is important for understanding the observed financial behavior of firms and, (ii) whether time-varying real investment opportunities or time-varying financial frictions are the key driving force behind corporate capital structure variation over time. In the first model, the firm always has real investment opportunities, capital adjustment is frictionless, and time-varying financial frictions in the debt market interact with the firm’s choice of capital structure (capital market driven model). In the second model, the firm’s real investment opportunities are time-varying, and capital adjustment is costly but there is no time-varying financial friction in the debt market (investment driven model). In the calibrated capital market driven model, the persistence of dividend, debt, and leverage is too low relative to the data. In the calibrated investment driven model, the persistence of dividend, debt, and leverage is reasonably close to the data. This result suggests that time-varying real investment opportunities, rather than time varying financial frictions, are the key driving force behind corporate capital structure variation over time. This finding holds in a model in which the firm faces both time-varying financial frictions, and time-varying real investment opportunities. The paper also shows that costly capital adjustment is important for understanding the observed persistence of dividend, debt, and leverage. Existing dynamic general equilibrium models have not been fully successful at explaining the high volatility of asset prices that we observe in the data. In the second essay, we construct a general equilibrium model with heterogeneous firms and financial frictions that addresses this issue. In each period only a fraction of firms can start new projects, which cannot be fully financed externally due to a financial constraint. We allow the tightness of the financial constraint to vary over time. Fluctuations in the tightness of the financial constraint result in fluctuations in the supply of equity and consequently in the price of equity. We calibrate the model to the U.S. data to assess the quantitative importance of fluctuations in the tightness of the financial constraint. The model generates a volatility in the price of equity comparable to the aggregate stock market while also fitting key aspects of the behavior of aggregate quantities. In third essay, we compare counterfactual corporate bond issuing dates to actual issuing dates in order to test the ability of firms to time the credit market. The 50 most active bond issuing financial firms and the 50 most active industrial firms are studied using one week, one month, and one quarter windows. The ability to time firm-specific CDS prices is studied from January 2002 - October 2009. The ability to time the riskfree rate (10 year US government bond) is studied from January 1988 - October 2009. We find that: firms do not successfully time the risk-free rate or the credit spreads. There is no evidence of CDS timing ability over one week or one month, but there is some borderline evidence at one quarter. For a typical bond issue, the firm loses about 1% of the face value of the bond relative to a 1 month window, due to their inability to time the market. If the firms could improve their market timing, they could save many hundreds of millions of dollars. Since there is a degree of statistical predictability in the data, we find it surprising that these firms are not able to do a better job of timing the credit market. i