A standard real business-cycle model with external habit and capital adjustment costs matches a long list of asset price and business-cycle moments: equity, firm value, and risk-free rate volatility; the equity premium; excess return predictability; consumption growth predictability; basic moments of consumption, output, and investment; among others. The model also generates endogenous consumption volatility risk. Precautionary savings motives make consumption sensitive to shocks in bad times, leading to countercyclical volatility, even with homoscedastic technology shocks. Habit acts as countercyclical leverage, which amplifies this channel. Habit also implies high risk aversion, which amplifies the stock price response.

A standard real business-cycle model with external habit and capital adjustment costs matches a long list of asset price and business-cycle moments: equity, firm value, and risk-free rate volatility; the equity premium; excess return predictability; consumption growth predictability; basic moments of consumption, output, and investment; among others. The model also generates endogenous consumption volatility risk. Precautionary savings motives make consumption sensitive to shocks in bad times, leading to countercyclical volatility, even with homoscedastic technology shocks. Habit acts as countercyclical leverage, which amplifies this channel. Habit also implies high risk aversion, which amplifies the stock price response. Received April 21, 2016; editorial decision February 3, 2017 by Editor Stijn Van Nieuwerburgh.

We study the design and incentive effects of contingent convertible debt. With contingent convertibles, the endogenous bankruptcy boundary can be at either of two levels: one with lower default risk or one at which default precedes conversion. An increase in debt moves the firm from the first regime to the second, a phenomenon we call debt-induced collapse. Setting the conversion trigger sufficiently high avoids this hazard. Given this condition, we investigate the effect of contingent capital and debt maturity on optimal capital structure, debt overhang, and asset substitution. We calibrate the model to large banks during the financial crisis.

We study the design and incentive effects of contingent convertible debt. With contingent convertibles, the endogenous bankruptcy boundary can be at either of two levels: one with lower default risk or one at which default precedes conversion. An increase in debt moves the firm from the first regime to the second, a phenomenon we call debt-induced collapse. Setting the conversion trigger sufficiently high avoids this hazard. Given this condition, we investigate the effect of contingent capital and debt maturity on optimal capital structure, debt overhang, and asset substitution. We calibrate the model to large banks during the financial crisis. Received April 10, 2015; editorial decision March 20, 2017 by Editor Leonid Kogan.