The magnitude and Cyclical Behavior of Financial Market Frictions

Figure 12

Leverage and Volatility of Idiosyncratic Risk

cannot be explained by the expected default probabilities derived from the option-

theoretic framework underlying the MKMV approach. Thus, once credit rating effects
are excluded, the model-implied spread
financial market frictions—bankruptcy costs and liquidity premiums—and would be
likely wider, requiring in turn a bigger μ_t.

The fit of the model, under the specification that excludes credit rating effects, is
greatly improved if we use the model-implied recovery rate as an alternative metric
to evaluate the BGG framework. In fact, as shown in the lower panel of Figure 11,
the model-implied recovery rate is now much closer to the actual recovery rate on
defaulted bonds, particularly since early 2001.

5.3 Limitations of the BGG Framework

In addition to the time-varying bankruptcy cost parameter μ_t, the other (unobserv-
able) key parameter of the BGG model that we solve for is σ_it , the firm-specific,
time-varying standard deviation of the idiosyncratic productivity shock. As shown
in Figure 12, the model implies a strong prediction between firms’ leverage and the

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