Deflation, Sticky Leverage and Asset Prices

Michael Weber, Christian Dorion, Alexandre Jeanneret and Harjoat Bhamra
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Christian Dorion: HEC Montreal
Alexandre Jeanneret: HEC Montreal

No 796, 2017 Meeting Papers from Society for Economic Dynamics

Abstract: We develop an asset pricing model with endogenous corporate policies to understand how deflation risk impacts real asset prices. Our key assumption is that nominal coupons paid to long-term corporate debt are fixed, i.e. leverage is sticky creating a nominal rigidity. Our model shows that deflation risk reduces real equity prices and increases equity return volatility. For the US economy, our model shows that deflationary episodes have a strong negative impact on real equity values, whereas inflationary episodes have a relatively mild positive impact. The overall impact of nominal risk on real equity values is therefore negative. In the cross-section, the model predicts that the negative impact of deflation risk on real equity values is stronger for high leverage firms. We find empirical support for our theoretical predictions.

Date: 2017
New Economics Papers: this item is included in nep-rmg
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed017:796

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