A theory of risk capital

Isil Erel; Stewart C. Myers; James A. Read

doi:10.1016/j.jfineco.2014.10.006

Journal of Financial Economics Vol. 118 No. 3 2015

A theory of risk capital

Isil Erel¹; Stewart C. Myers²; James A. Read³

¹ Fisher College · ² MIT Sloan School of Management, 100 Main Street, E62-620, Cambridge, MA 02142, USA · ³ The Brattle Group, 44 Brattle Street, Cambridge, MA 02138, USA

Abstract

We present a theory of risk capital and of how tax and other costs of risk capital should be allocated in a financial firm. Risk capital is equity investment that backs obligations to creditors and other liability holders and maintains the firm׳s credit quality. Credit quality is measured by the ratio of the value of the firm׳s option to default to the default-free value of its liabilities. Marginal default values provide a full and unique allocation of risk capital. Efficient capital allocations maintain credit quality and preclude risk shifting. Our theory leads to an adjusted present value (APV) criterion for making investment and contracting decisions. We set out implications for risk management and corporate finance.

DOI: 10.1016/j.jfineco.2014.10.006
Volume: 118
Issue: 3
Pages: 620-635
Language: en
Sources: openalex crossref bibtex:phds-export.bib

A theory of risk capital

Abstract

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