Counterparty effects on capital structure decision in incomplete market

a r t i c l e i n f o JEL classification: G32 G31 G33 C61 Keywords: Counterparty effect Market incompleteness Optimal capital structure This paper builds a static contingent-claim model that allows for examining the optimal capital structure with the joint arguments of counterparty default risk and market incompleteness. A first-passage-time model with jump default barrier is adopted to capture the counterparty effects on the pricing of defaultable claims. Following the framework of Jarrow and Yu (2001), the jump in primary firm's bankruptcy barrier is designed as the loss on capital resulted from secondary firm's bankruptcy. The relevance of market incompleteness in the context of claim-pricing is considered using " good-deal asset price bound " method by Cochrane and Saa-Requejo (2000). We show that the effects of counterparty's default clearly diminish the uses of debt, which indirectly explains the so-called under-leveraged puzzle. We further find that counterparty effects on capital structure are sensitive to market incompleteness and firm's characteristics, such as tax rate and bankruptcy cost rate. Since the seminar work by Modigliani and Miller (1958), there is a vast literature on corporate finance that devotes to explaining the central anomaly related to firm's financing decision: low leverage-use (so-called underleveraged puzzle). The issues on such a subject explored by prior research include agency costs A consensus view underlying these works is that bankruptcy costs derived from standard structural model are too small to offset the value of tax shields, and thus, other cost-factors must be introduced into trade-off analysis to explain observed capital structures. Motivated by this idea, the paper intends to address the central question on capital structure theory from the arguments of counterparty defaults. The reason of why this study puts a special focus on counterparty's default risk is sketched as follows. In view of credit contagion and clustering of default during the credit crises, many of the studies hold that the standard credit models without considering counterparty effects (e.g., Merton, 1974) will under-predict a firm's default risk and mis-estimate the value of derivatives on defaultable assets, such as credit default swap. To overcome this modeling restriction, a class of works on the counterparty risk has been motivated. Jarrow and Yu (2001) pioneer in pricing the default-risky securities with counter-party risk using reduced-form model, proposed by Jarrow and Turnbull (1995). Except for Jarrow and Yu, subsequent works on the pricing of credit default swap that particularly …