This study seeks to empirically test whether equity value reflects gains and losses associated with changes in debt value that arise from changes in credit risk. Merton (1974) establishes this effect theoretically. However, direct empirical evidence is lacking. The question relates to the implications of using fair value accounting for liabilities, which would include recognizing in income what some view as anomalous effects on equity value of changes in credit risk.
The representative agent model has long been an important workhorse for economics and in the last 3 decades it has become the dominant macroeconomic approach. Todayns representative agent models are characterized by an explicitly stated optimization problem of the representative agent, which can be either a consumer or a producer. The derived individual demand or supply curves are then in turn used for the corresponding aggregate demand or supply curves. The moments of the aggregates in these models are then compared with time series observations of the macroeconomy. Implicit in this approach is that any underlying heterogeneity across agents or firms averages out and does not have any implications for the behaviour of the aggregate economy. An aggregate shock whether to technology or to nominal demand generates a spread&preserving mean shift in the economy. However, Haltiwanger (1997) has argued that statistical agencies should report the higher moments of economic activity; for example, the distribution of aggregate output across sectors and firms. Moreover, recent research into the cross sectional distribution of behaviour at business cycle frequencies has raised some questions about the usefulness of the representative agent model for explaining certain regularities. In particular the shape of the cross section is sensitive to business cycle shocks. Macroeconomic shocks do not have a spread preserving effect on the behaviour of firms. Evidence for the US (Higson et al (2003)), for the UK (Higson et al, 2004), Germany (Dopke et al, 2005) and Italy (Santoro, 2005) suggests a systematic tendency for the cross sectional distribution in firm growth rates to vary with the business cycle.
These stylised facts of the business cycle need some explanation. In this paper we consider a model of heterogeneous firms functioning in imperfectly competitive markets who may be in different financial states. Bernanke and Gertler (1989), Greenwald and Stiglitz (1993), Kiyotaki and Moore (1997), Bernanke et al. (1996, 1999) show that in the presence of asymmetric information, financing constraints can be important for both investment and production decisions.
The more recent literature, however, is essentially concerned with the emergence of financial fragility in a perfect competition setting on the real side of the economy. The model of Greenwald and Stiglitz assumes that each firm faces an infinitely elastic demand function subject to a random idiosyncratic shock, which captures uncertainty regarding relative prices. Uncertainty arises because firms are price takers and there is a one&period lag between when firms borrow on the credit market, hire workers and production takes place, and when they sell their output. Firms are unable to raise external finance on the stock market because of equity rationing (Greenwald et al. (1984) and Myers and Majluf (1984)). Therefore, they rely on internally generated funds as the primary source of funding and resort to bank credit if internal funds are insurcient to finance the wage bill. As a consequence, firms face an explicit risk of bankruptcy.
Why does stock market volatility vary over time? Economists have been intrigued by this issue for decades. For example, Schwert (1989a) finds that the volatility of no single macroeconomic variable could help explain low frequency movements of aggregate stock market volatility. Yet stock market volatility is related to the business cycle. Indeed, a number of empirical studies confirm Schwert’s (1989a and 1989b) further findings that the volatility of stock returns is higher in bad times than in good times (see, e.g., Brandt and Kang, 2004, and the additional evidence provided here). This paper addresses an important but still unanswered question: Why is stock market volatility asymmetric over the business cycle?
My central result is that in economies with rational expectations, return volatility is countercyclical because risk premia (i.e. the compensation investors require to invest in the stock market) change asymmetrically in response to variations in economic conditions. That risk premia are countercyclical has been a widely known empirical fact since the seminal contributions of Fama and French (1989) and Ferson and Harvey (1991). However, the main message of this paper is not a simple statement that risk premia must be countercyclical to generate countercyclical return volatility. Rather, the crucial point is that to induce countercyclical return volatility, risk premia must increase more in bad times than they decrease in good times, a new hypothesis which I support with substantial empirical evidence.
