Myron Scholes (2008) - The Role of Liquidity and Risk Transfer Services in the Economy

Myron Scholes (2008)

The Role of Liquidity and Risk Transfer Services in the Economy

Myron Scholes (2008)

The Role of Liquidity and Risk Transfer Services in the Economy

Abstract

The famous research of Modigliani-Miller on corporate finance (both Nobel Prize winners in Economics) proved that the value of a corporation was independent of the way it financed its operations. Although debt appears less expensive than equity, additional debt (more leverage) requires the expected rate of return on equity increase sufficiently such that the cost of capital for the firm is left unchanged. Although bankruptcy costs might constrain firm leverage, the largest deadweight costs of debt appear to be the costs of deleveraging; that is, decreasing leverage to maintain some level of risk if the value of assets fall. Firms need to assess how much flexibility to build into their operating and financing programs. For inflexible firms, the costs of altering their assets and liability mixes might be extremely expensive. A case in point is the current global financial crisis, as exemplified by the inability of financial firms to deliver. The apparent need for government bailouts leads to questions as to appropriate regulatory responses and the optimal capital structures and risk management policies for these entities going forward.

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