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Debt collateralization, capital structure, and maximal leverage

Author

Listed:
  • Feixue Gong

    (Massachusetts Institute of Technology)

  • Gregory Phelan

    (Williams College)

Abstract

We study the effects of allowing risky debt to be used as collateral in a general equilibrium model with heterogeneous agents and collateralized financial contracts. With debt collateralization, investors switch to using exclusively high-leverage contracts for every investment they choose (issuing risky debt when possible). High-leverage positions maximize the ability of contracts to serve as collateral, expanding the set of state contingencies created from collateralized debt. We provide conditions under which debt collateralization will increase the price of the underlying asset. Our results also apply to variations in capital structure since many capital structures implicitly provide the ability to use debt contracts as collateral.

Suggested Citation

  • Feixue Gong & Gregory Phelan, 2020. "Debt collateralization, capital structure, and maximal leverage," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 70(2), pages 579-605, September.
    • Handle: RePEc:spr:joecth:v:70:y:2020:i:2:d:10.1007_s00199-019-01222-7
    DOI: 10.1007/s00199-019-01222-7
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    References listed on IDEAS

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    More about this item

    Keywords

    Leverage; Incomplete markets; Asset prices; Default; Securitized markets; Asset-backed securities; Collateralized debt obligations;
    All these keywords.

    JEL classification:

    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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