Deflation, Sticky Leverage and Asset Prices

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.