| In a dynamic contingent claim model that features endogenous default, debt restructuring, risk shifting and adjustment policies, I examine the risk shifting problem and its asset pricing implications. Because of limited liability, equity holders can shift downside risk to debt holders by delaying filing for bankruptcy or taking on risky projects in a hope of avoiding bankruptcy. In a repeated game, equity holders consequently bear all the costs for their opportunistic behavior if they manage to avoid bankruptcy and come back to debt markets to restructure their debt. They need to hedge the increased asset risk back down to the original low level in order to enjoy low costs of debt and high tax benefits. My model provides a unified framework to reconcile two well-known empirical asset pricing results. Debt holders of the same firm who rationally anticipate the potential risk shifting problem demand high risk premiums in the form of credit spreads (Campbell and Taksler, JF, 2003). In contrast, because equity holders can delay filing for bankruptcy and further increase idiosyncratic volatility to reduce their downside risk exposure, their expected stock returns decrease with volatility (Ang et al., JF, 2006). |
