The Cost of Debt for a Financial Firm

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Abstract
We model a financial firm that finances securities trading by issuing debt. Since there is a possibility of default, the interest rate offered on the debt includes a default premium. In this context the financial firm has to decide (i) how much debt to issue; and (ii) what its cost of capital is. In other words, we derive the cost-of-carry of a position in risky securities. Simultaneously with deciding its liability structure, the firm decides how much risk exposure to take on its assets. A central part of our analysis is to explain how the promised yield and the expected return to the debtholders are related to the cost of capital. Liability structure and investment policy are linked: for a given liability structure (with a given default premium) chosen in anticipation of particular investment opportunities, the financial firm may subsequently be unable to invest profitably in low risk assets even though they would have been profitable with a different capital structure. While the traditional analysis emphasizes the limited liability option conferred by bankruptcy, in our model the firm also considers that bankruptcy may damage its ability to survive and make future profits. Although we model a pure financial firm that finances securities trading with risky debt (such as a securities firm or hedge fund), the analysis can also be applied to the capital budgeting decisions of non-financial firms.

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