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Macroeconomic Conditions and the Puzzles of Credit Spreads and Capital Structure



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    • Hui Chen is at the Sloan School of Management, Massachusetts Institute of Technology. The paper is based on my Ph.D. dissertation at the Graduate School of Business, University of Chicago. I am very grateful to the members of my dissertation committee, John Cochrane, Doug Diamond, and Pietro Veronesi, and especially to the committee chair Monika Piazzesi for constant support and many helpful discussions. I also thank Heitor Almeida, Ravi Bansal, Pierre Collin-Dufresne, Darrel Duffie, Gene Fama, Dirk Hackbarth, Lars Hansen, Campbell Harvey (the Editor), Andrew Hertzberg, Francis Longstaff, Jianjun Miao, Erwan Morellec, Stewart Myers, Tano Santos, Martin Schneider, Costis Skiadas, Ilya Strebulaev, Suresh Sundaresen, two anonymous referees, and seminar participants at Carnegie Mellon University, Columbia University, Duke University, Emory University, Hong Kong University of Science and Technology, London Business School, MIT, New York University, Stanford University, University of California at Los Angeles, University of Chicago, University of Illinois, University of Maryland, University of Michigan, University of Rochester, University of Southern California, University of Texas at Austin, University of Toronto, University of Washington, and the 2007 WFA meetings for comments. All remaining errors are my own. Research support from the Katherine Dusak Miller Ph.D. Fellowship in Finance is gratefully acknowledged.


I build a dynamic capital structure model that demonstrates how business cycle variation in expected growth rates, economic uncertainty, and risk premia influences firms' financing policies. Countercyclical fluctuations in risk prices, default probabilities, and default losses arise endogenously through firms' responses to macroeconomic conditions. These comovements generate large credit risk premia for investment grade firms, which helps address the credit spread puzzle and the under-leverage puzzle in a unified framework. The model generates interesting dynamics for financing and defaults, including market timing in debt issuance and credit contagion. It also provides a novel procedure to estimate state-dependent default losses.