Seminar – Optimal Leverage and Maturity in a Simple Structural Model

Professor Hayne Leland, Haas School of Business

We extend a widely used structural model of the firm with constant debt rollover (Leland (1994b, 1998)) to study optimal debt maturity as well as leverage. Consistent with the empirical findings of Longstaff, Mithal and Neis (2005), Bao, Pan, and Wang (2011), and others, we introduce debt il(liquidity) costs that increase with debt maturity. We derive closed-form formulas for debt and equity values that are subsequently used to determine optimal maturity and leverage jointly. While addressing the impact of illiquid debt, the model is considerably simpler than those of He and Xiong (2012) and He and Milbradt (2014). Optimal maturity balances the advantages of longer-term debt in reducing rollover costs and a lower default boundary with its liquidity disadvantage. The calibrated model fits leverage, maturity, spreads, and 1920-2017 default data remarkably well. We develop complete comparative static results for both optimal leverage and maturity and show that the effect of parametric changes on leverage are typically muted when maturity can adjust simultaneously. We apply our calibrated model to the “leverage rachet effect” of Admati, DeMarzo, Hellwig, and Pfleiderer (2016), and recently studied in Leland and Hackbarth (2019). For realistic parameters, we find the magnitude of equity benefits of ratcheting are small and may become negative for short term debt. We also examine Feldhutter and Schaefer’s contention that basic structural models without jumps, liquidity costs, or other modifications can explain yield spreads when calibrated to long term default data.

Speaker bio

Hayne E. Leland is Professor Emeritus at the Haas School of Business, University of California, Berkeley, and is a former President of the American Finance Association. A graduate of Harvard (AB and PhD) and the London School of Economics (MSc Econ), he is the author of more than 50 articles in finance and economics. His research focuses on asset management, corporate financial structure, financial intermediation, and option valuation.

His research has received numerous awards. In 2016, he was honoured as the Financial Engineer of the Year by the International Association of Quantitative Finance. In 2012 he served as the inaugural Pembroke Visiting Professor in International Finance at the University of Cambridge (UK), and in 2008 was the first recipient of the $100,000 Stephen A. Ross Award for Research in Financial Engineering. He received an Honorary Doctorate degree from the University of Paris (Dauphine) in 2007. In addition to this a founding principal of Leland O’Brien Rubinstein (LOR), he was named one of Fortune Magazine’s “Businessmen of the Year” in 1987.

Besides continuing his research in corporate finance and capital markets, Professor Leland is currently developing innovative financial structures that allow energy market participants to hedge future resource production, and investment funds that assure minimum levels of income during retirement years. He is also involved with colleagues in developing home equity sharing contracts as an alternative/supplement to debt only home finance.