PUB - Publikationen an der Universität Bielefeld

The traditional valuation formulas for corporate debt, which are derived in a complete market setting and are based on the no-arbitrage principle, imply that equity prices become more volatile as leverage increases. If the asset structure is incomplete, the presence of corporate debt affects the linear subspace spanned by the payoffs of the existing assets, and the pricing of corporate debt and shares of levered firms becomes a simultaneous valuation problem. This paper characterizes the relationship between the price of corporate debt and the share price of a levered firm in an equilibrium framework where corporate debt is a non-redundant asset. While, in the absence of bankruptcy, higher leverage always implies riskier equity, it does not necessarily mean more volatile equity prices. In fact, the link between leverage and equity price volatility depends in a particular way on investors’ preferences towards risk.