This dissertation investigates agents’ behavior in a world with financial frictions such as financial regulations and information asymmetries. The three chapters of the dissertation are devoted to answering the following questions: Does financial regulation slow credit supply growth by imposing higher lending standards on banks? How does business volatility contribute to the declining firm entry rate in recent decades through credit channel? How does a financially distressed firm respond to risks when it is deemed "too big to fail"? Although widely acknowledged for enhancing financial stability, the Dodd-Frank Act (DFA) has continued to attract criticisms arguing that it contracts credit supply, and, as a consequence, reduces GDP and creates pressure on unemployment. In chapter I, I provide empirical and theoretical evidence on DFA’s negative impacts on credit supply. Based on a structural banking model, I find that DFA has reduced credit supply by at least 3.1% of the current volume of bank credit. This sizable loss partially validates the concern that the Wall Street reform put a strain on the economy and prevented it from fully recovering through credit channels. In chapter II, I present empirical and theoretical evidence suggesting that unexpected surging economic uncertainty hurts startups through credit channel: rising default rates accompanying heightened economic turbulence drive up credit spreads. With startups facing increasing funding costs, entry barriers go up and entry rates decline. Through simulations of an industry model incorporating dynamic entry and exit, I show that unexpected uncertainty shocks can generate larger and more persistent impact on economic outputs in a world with financial frictions than that without the frictions. In Chapter III, I argue that the risk-taking behavior of a financially distressed firm is exacerbated if the equity holders have larger bargaining power over debt holders. Using a firm’s valuation model which permits the endogenous default on the debt, I show that the threshold value triggering risk-taking behavior is positively related to the equity holders’ bargaining power in debt renegotiations. Therefore, firms anticipating a final bailout intentionally undertake more risky investments.

The equity holders of a firm typically control investment choices but enjoy limited liability, since the value of equity is the firm’s value in excess of the value of debt and other fixed claims. The asset substitution problem allows equity holders to expropriate value from other claimants by shifting downside risk from failed projects. To do so, equity holders substitute riskier investments for those with less risk. In the context of tax choices, firms pursue uncertain tax projects to reduce their current or future tax payments. Given the negative consequences of tax uncertainty documented by prior studies, understanding why firms pursue more uncertain tax projects is important for both internal and external stakeholders. In this study, I construct a model of the firm that highlights how asset substitution incentives influence the adoption of uncertain tax projects. I confirm the inferences from this model empirically to illustrate when firms are more likely to prefer more uncertain tax projects due to the investment distortion created by asset substitution incentives. Specifically, I find that firms in financial distress, firms with high growth potential, and loss firms adopt more uncertain tax projects than other firms. These results provide relevant insight for debt holders, regulators, and enforcement bodies.

This volume consists of four papers, which in principle could be read in any order. The common denominator is that they deal with contingent claims models of a firm's securities or related derivatives. A Framework for Valuing Corporate Securities Early applications of contingent claims analysis to the pricing of corporate liabilities tend to restrict themselves to situations where debt is perpetual or where financial distress can only occur at debt maturity. This paper relaxes these restrictions and provides an exposition of how most corporate liabilities can be valued as packages of two fundamental barrier contingent claims: a down-and-out call and a binary option. Furthermore, it is shown how the comparative statics of the resulting pricing formulae can be derived.A New Compound Option Pricing ModelThis paper extends the Geske (1979) compound option pricing model to the case where the security on which the option is written is a down-and-out call as opposed to a standard Black and Scholes call. Furthermore, we develop a general and flexible framework for valuing options on more complex packages of contingent claims - any claim that can be valued using the ideas in chapter 1. This allows us to study the interaction between the detailed characteristics of a firm's capital structure and the prices of for example stock options.Implementing Firm Value Based ModelsThis paper evaluates an implementation procedure for contingent claims models suggested by Duan (1994). Duan's idea is to use time series data of traded securities such as shares of common stock in order to estimate the dynamics of the firm's asset value. Furthermore, we provide an argument which allows us to relax the (common) assumption that the firm's assets may be continuously traded. It is sufficient to assume that the firm's assets are traded at one particular point in time.Asset Substitution, Debt Pricing, Optimal Leverage and MaturityChapters 1-3 have focused on the problem of pricing corporate securities.They have thus abstracted strategic aspects of corporate finance theory. This paper is an attempt to combine the contingent claims literature with the non-dynamic corporate finance literature. I allow the management of the firm to alter its investment policy strategically. This yields a model which allows us to examine the relationship between bond prices, agency costs, optimal leverage and maturity. / Diss. Stockholm : Handelshögsk.

This study investigates the determinants and effects of currency and asset substitution in Turkey using quarterly data from 1987:1 to 2002:4. The empirical results from the application of Johansen procedure to a four-variable system containing currency-asset substitution proxy (M2Y/M2)), real income, real exchange rate, and ratchet effect proxy (past peak values of the depreciation of the real exchange rate) suggest the presence of a single cointegration vector among the variables. The results further suggest the endogeneity of the degree of currency substitution for the parameters of the cointegration vector. According to the theory consistent and data-acceptable long-run relationship between the variables, there is a strong ratchet (hysteresis) effect in currency-asset substitution in Turkey. The study contains also the policy implications of both currency substitution and the ratchet effect arising from real exchange rate change shocks in the Turkish economy.

This paper proposes that managerial incentive compensation affects the firm choice between public and bank debt. To motivate the case I analyze a simple model with complete and perfect information that implies a positive relation between managers’ incentive compensation and preference toward bank debt. Using firm-level data over the period 1992-2005, I empirically examine the relation between managerial incentives and financing decisions. Specifically, I examine whether managers whose compensation is tied to firm performance choose bank over public debt as a commitment mechanism to reduce the cost of debt. Consistent with a monitoring role of banks, I find that the probability of choosing bank over public debt is positively related to the level of incentive compensation. Further, I find that public lenders price the incentive alignment between manager and shareholders by increasing the cost of debt, while the overall cost of bank loan does not depend on the manager’s incentive compensation. Finally, I find that banks are more likely to include a collateral provision in the debt contract if the manager’s compensation is tied to firm performance.