"Leverage and Risk-Taking" with Florian Heider

Abstract:

Contrary to the prediction of static models, risk-taking is non-monotonic in leverage in dynamic models. If lenders rationally anticipate risk-shifting of high-leverage firms, then equity-holders bear the cost of risk-shifting via higher debt interest rates. The higher cost of risk-shifting makes equity holders avert risk at medium levels of leverage. Averting risk today preserves the option to issue safe, i.e., cheap, debt tomorrow. The same friction responsible for risk-taking of high-leverage firms leads medium-leverage firms to avert risk. Our model is able to reconcile contradictory empirical results on the relation between risk and leverage, predicts that firms with medium leverage are subject to investment distortions, and helps explain the low-leverage puzzle.