Stochastic Volatility , Bond Yields , and the Q Theory of Investment ∗

Recent empirical work using panel data documents that, while the correlation of investment and Tobin’s Q is low, the correlation of investment and credit spreads is high. We propose an explanation for these empirical findings, based on time-varying risk, i.e. stochastic volatility. In our model, firms finance investments using defaultable debt as well as equity issuance, and they are subject to standard profitability shocks as well as shocks to volatility. An increase in volatility leads to an increase in the probability of default and hence the credit spread, while reducing investment and increasing equity value. This shock hence generates a negative correlation between investment and credit spreads, and between investment and Q, helping the model match the data. JEL Codes: G30, G32.