Default Risk, Asset Pricing and Equity Premium∗

The evaluation and control of an agent‘s debt has become a major issue in economics. In this paper we focus on firms and study credit risk, debt control and asset valuation of firms. We demonstrate that firm specific credit constraints and endogenous risk premia, based on collateralized borrowing, affect the asset value of the firm and, in turn, the collateral value of the firm. In order to explore the interdependence of debt finance and asset pricing of firms we endogenize default premia and borrowing constraints in a production based asset pricing model. In this context then the dynamic decision problem of maximizing the present value of the firm faces an additional constraint giving rise to the debt dependent firm value. We solve for the asset value of the firm with debt finance by the use of numerical dynamic programming. This allows us to solve the debt control problem and to compute sustainable debt as well as firm value. We also discuss results from stochastic version of our model as well as the implications of our study for the equity premium puzzle. We want to thank John Donaldson, Martin Lettau, Buz Brock and Harald Uhlig for helpful comments on a previous version of the paper. We also want to thank participants in a workshop at the University of Technology, Vienna, the Macroeconomic Workshop at Columbia University, and the SCE conferences at Yale University, June 2001 and Aix-enProvence, July 2002, and participants of the workshop on Economic Dynamics in Leiden, June 2002 and the CFS workshop on New Directions in Financial Risk Management, November 2003. An abridged version is forthcoming at the Journal of Financial Econometrics. Mathematical Institute, University of Bayreuth, Germany, e-mail:[email protected] Center for Empirical Macroeconomics, Bielefeld and New School University, New York, e-mail:[email protected]