Are Corporates' Target Leverage Ratios Time-Dependent?

by Cho-Hoi Hui of the Hong Kong Monetary Authority
Chi-Fai Lo of the Chinese University of Hong Kong, and
Ming-Xi Huang of the Chinese University of Hong Kong

September 2006

Abstract: This paper extends the stationary-leverage-ratio model to incorporate a time-dependent target leverage ratio. The theoretical hypothesis of the existence of a time-dependent target leverage ratio reflects the movement of a firm's initial target ratio toward a long-term target ratio over time. Using some simple scenarios about the time-dependence of the target leverage ratio, the numerical results show that the incorporation of the hypothesis into the stationary-leverage-ratio model is capable of producing term structures of probabilities of default that are consistent with some empirical findings. The results provide some evidences to support the hypothesis.

JEL Classification: G13, G21, G28.

Keywords: Credit Risk Models, Credit Ratings, Default Probability.

Published in: International Review of Financial Analysis, Vol. 15, No. 3, (September 2006), pp. 220-236.

Previously titled: Estimation of Default Probability by Three-Factor Structural Model

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