Counterparty effects on capital structure decision in incomplete market

Chang Chih Chen*, So De Shyu, Chih Yuan Yang

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

6 Citations (Scopus)


This paper builds a static contingent-claim model that allows for examining the optimal capital structure with the joint arguments of counterparty default risk and market incompleteness. A first-passage-time model with jump default barrier is adopted to capture the counterparty effects on the pricing of defaultable claims. Following the framework of Jarrow and Yu (2001), the jump in primary firm's bankruptcy barrier is designed as the loss on capital resulted from secondary firm's bankruptcy. The relevance of market incompleteness in the context of claim-pricing is considered using "good-deal asset price bound" method by Cochrane and Saa-Requejo (2000). We show that the effects of counterparty's default clearly diminish the uses of debt, which indirectly explains the so-called under-leveraged puzzle. We further find that counterparty effects on capital structure are sensitive to market incompleteness and firm's characteristics, such as tax rate and bankruptcy cost rate.

Original languageEnglish
Pages (from-to)2181-2189
Number of pages9
JournalEconomic Modelling
Issue number5
Publication statusPublished - 2011 Sept
Externally publishedYes


  • Counterparty effect
  • Market incompleteness
  • Optimal capital structure

ASJC Scopus subject areas

  • Economics and Econometrics


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