Growth Options and Credit Risk

We calibrate a dynamic model of credit risk and analyze the relation between growth options and credit spreads. Our model features real and financing frictions, a technology with decreasing returns to scale, and endogenous investment options driven by both systematic and idiosyncratic shocks. We find a negative relation between credit spreads and growth options after controlling for determinants of credit risk. This negative relation is a result of the current decision to invest and the associated change in leverage, which, in the presence of external financing needs and financing frictions, increase credit spreads while reducing the value of future investments. We do not find evidence that growth options accrue value in response to systematic risk, thus increasing credit risk premia.

This paper was accepted by Karl Diether, finance.