Optimal Capital Structure and Endogenous Default

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Rogers, L.C.G. and Bianca Hilberink, "Optimal Capital Structure and Endogenous Default", Finance and Stochastics, Vol. 6, No. 2, (April 2002), pp. 237-263.

Abstract: In a sequence of fascinating papers, Leland and Leland and Toft have investigated various properties of the debt and credit of a firm which keeps a constant profile of debt and chooses its bankruptcy level endogenously, to maximise the value of the equity. One feature of these papers is that the credit spreads tend to zero as the maturity tends to zero, and this is not a feature which is observed in practice. This defect of the modelling is related to the diffusion assumptions made in the papers referred to; in this paper, we take a model for the value of the firm's assets which allows for jumps, and find that the spreads do not go to zero as maturity goes to zero. The modelling is quite delicate, but it just works; analysis takes us a long way, and for the final steps we have to resort to numerical methods.

JEL Classification: G32, G33.

Keywords: Cumulative Default Probability, Structural Model, Jump-Diffusion, Endogenous Capital Structure, Esscher Transform, Kou Processes.

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