Principles of smooth and continuous fit in the determination of endogenous bankruptcy levels |
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Authors: | A E Kyprianou B A Surya |
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Institution: | (1) Department of Mathematical Sciences, The University of Bath, Bath, BA2 7AY, UK;(2) Mathematical Institute, University of Utrecht, Budapestlaan 6, 3584 CD Utrecht, The Netherlands |
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Abstract: | We revisit the previous work of Leland J Finance 49:1213–1252, 1994], Leland and Toft J Finance 51:987–1019, 1996] and Hilberink
and Rogers Finance Stoch 6:237–263, 2002] on optimal capital structure and show that the issue of determining an optimal
endogenous bankruptcy level can be dealt with analytically and numerically when the underlying source of randomness is replaced
by that of a general spectrally negative Lévy process. By working with the latter class of processes we bring to light a new
phenomenon, namely that, depending on the nature of the small jumps, the optimal bankruptcy level may be determined by a principle
of continuous fit as opposed to the usual smooth fit. Moreover, we are able to prove the optimality of the bankruptcy level according to the appropriate choice of fit.
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Keywords: | Credit risk Endogenous bankruptcy Scale functions Fluctuation identity Continuous and smooth pasting principles Wiener– Hopf factorization |
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