An endogenous structural credit risk model incorporating with moral hazard and rollover risk

In this paper, we embed optimal contracting between the manager and equity holders into Leland-Toft endogenous structural credit risk model to study the impact of moral hazard on the firm's credit risk with rollover debts. Our model quantitatively shows that the agency costs induced by the moral hazard can endogenously have significant impacts on credit spreads, besides the costs of rolling over the maturing debts of the firm. It originates from the conflicts that these two costs should be covered by equity holders while both the manager and maturing debt holders are still paid in full. The numerical results show that the credit spread with the agency costs of moral hazard is larger than the one without the agency costs. Thus, the moral hazard could be used to explain “credit spread puzzle” as an endogenous factor. The explicit formulae of the equity value, the debt value, and the endogenous default boundary are also given.