ELSEVIER
Journal of Financial Economics42 (1996)333364
JOURNAL
OF
Financial
ECONOMICS
Leasing and credit risk
Steven R. Grenadier
Graduate School ()/' Business, Stanjord University, Stan/brd, CA 943055015, USA
Received September 1995; final version received March 1996)
Abstract
Despite empirical evidence pointing to a strong similarity between lease contracts and junk bonds, the theoretical modeling of equilibrium lease determination has been confined primarily to defaultfree leases. This paper provides a unified framework for determining the equilibrium credit spread on leases subject to default risk. The model is flexible enough to be applied to a wide variety of realworld leasing structures, including security deposits, required upfront prepayments, embedded lease options, leases indexed to use, and lease credit insurance contracts.
Key words: Leasing; Options; Credit risk
JEL
classification: GI2; G13; G32
1.
Introduction
Leasing is olden perceived as a substitute for debt for firms that are 'too risky or are unable to access conventional debt markets' (Lease, McConnell, and Schall heim, 1990). In the U.S., almost onethird of total business investment is leased. In 1993, equipment leasing alone was valued at over $125 million, with smaller firms representing a disproportionately large share of this activity. Despite em pirical evidence pointing to a strong similarity between lease contracts and junk bonds, the theoretical modeling of equilibrium lease determination has been virtu ally confined to defaultfree leases (a notable exception is Lewis and Schallheim, 1992, who take into account default risk in a singleperiod model of the equi librium rental rate). Given the large volume of research devoted to the study of corporate bond credit risk, it is puzzling that the risk of leasing has been largely ignored. A model of lease default risk is important not only for the determination
Comments from Geert Bekaert, Michael Harrison, Patric Hendershott, Craig Lewis (the rcferee), John Long (the editor), Tim Riddiough, C.F. Sinnans, and Richard Stanton are gratefully acknowledged.
0304405X/96/$15.00 © 1996 Elsevier Science S.A. All rights reserved
PIISO304405X(96)008823
334 X R. Grenadier/.lournal q[ Financial Economics
42 (1996) 333 364
of equilibrium rental rates, but also fbr an understanding of the wide variety of lease clauses and conventions that are written to deal explicitly with credit risk. This paper provides a unified framework for determining the equilibrium credit spread on leases subject to default risk, and applies the results to sev eral realworld leasing arrangements such as security deposits, required upfront prepayments, embedded lease options, leases indexed to use, and lease credit insurance contracts. The perception that credit risk plays a significant role in leasing arrangements is reinforced by much of the empirical literature on lease yields. Early empirical work expressed surprise at the observation that yields on lease contracts exceeded, by a wide margin, yields on approximately equivalent debtfinancing arrange ments. Crawford, Harper, and McConnell (1981)report that the leases in their sample were written with yields significantly higher than returns on BBB bonds during the same period. This confirmed the results of an earlier study by Sorensen and Johnson (1977). In perhaps the largest study of lease yields, Schallheim, Johnson, Lease, and McConnell (1987), using a sample of 363 contracts, find that lease yields are set to compensate the lessor for the default potential inherent in leasing contracts. In particular, both the size and the liquidity ratio of the lessee had significant explanatory power in determining the lease yield. The smaller the lessee and the lower its liquidity ratio, the higher the lease rate was set. 1 A strong analogy can be made between lease contracts and highyield (junk) bonds. Altman (1989) and Asquith, Mullins, and Wolff (1989) report that cumu lative default rates on such bonds are about 30% over the life of the bonds. On those bonds that do default, only about 40% of the face value is recovered. A study of the ex post pertbrmance of leases by Lease, McConnell, and Schallheim (1990) finds that leases display similar default properties. The leases in their sample experienced a default rate of approximately 20% and a recovery rate of 38% relative to the original cost of the asset, or 64% relative to the present value of the remaining lease payments plus estimated salvage value. In addition, the spread between contracted and observed yields on leases closely matches that on junk bonds. For the sample by Lease, McConnell, and Schallheim, the contract yield exceeds the realized return by 2.62% over the 19731982 period. Blume and Keim (1991) find that for lowergrade bonds issued during 1977 1978 the promised yield exceeds the realized return by 2.61%. Thus, there is evidence that leases and highyield bonds are not entirely dissimilar. The underlying approach of this paper is in the tradition of Miller and Upton (1976) and Grenadier (1995), with the focus on the economic aspects of leasing. Leasing is simply a mechanism for selling the use of an asset for a specified
1However. two other variables that could proxy for default risk, the lessee's return on assets and leverage ratio, did not have significant explanatory power. Schallheim (1994) states that 'perhaps the lessees" size and liquidity ratios capture the default potential in the sample to such a degree that the other two ratios do not help explain lease yields'.
S.R.
Grenadier/Jourmd o! Financial Economics 42 (1996)
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335
period of time, without necessitating a transfer of ownership. Thus, leasing pro vides a separation of ownership from use, with the lessee receiving the benefits of use and the lessor receiving the lease payment flow plus the residual value of the asset. The economic framework of the model facilitates an optionpricing approach to equilibrium lease valuation. This approach has been followed by sev eral authors. Smith (1979) provides an optionlike characterization for a lease: a Tyear lease is economically equivalent to a portfolio that simultaneously pur chases the underlying asset and writes a European call option on the asset with expiration date T and zero exercise price. McConnell and Schallheim (1983) and Schallheim and McConnell (1985) use an optionpricing framework to provide a thorough analysis of a wide variety of lease options and insurance contracts. Grenadier (1995) combines an optionpricing approach with a competitive indus try equilibrium to provide a unified framework for valuing leases. While this approach is intuitive and facilitates tackling some of the more com plicated aspects of realworld leasing, it also neglects some very important leasing considerations. In particular, there is a vast literature on the importance of taxes in the leaseversusbuy decision (e.g., Schall, 1974; Myers, Dill, and Bautista, 1976; Brealey and Young, 1980; Lewis and Schallheim, 1992). While the present analysis focuses on the nontax aspect of leasing, the inclusion of tax considera tions would add greater realism to the analysis. Unfortunately, incorporating tax considerations into the present model would vastly increase its complexity. This paper begins with a model of the equilibrium determination of lease rates when the payments are subject to default risk. In equilibrium, the promised lease payments must compensate the lessor for both the forgone use of the asset and the potential consequences of default. In the model, the underlying asset's value evolves stochastically. The event of default is determined when the lessee's stochastic cash flow (or asset value) falls to a lower default barrier. Upon default, the lessor receives only a fraction of the lease's value due to the costs of default. However, in equilibrium, the contracted lease rate is set such that the lessor is indifferent between lessees of different credit quality. The lease credit spread is determined such that any sale of the use of the asset over a given period of time must have the same equilibrium valuation. Following an analysis of lease credit risk in general, I move on to analyze some of the most common leasing conventions that deal directly with credit risk. To motivate the applications, consider the following examples of realistic leasing arrangements:
1. Your company is negotiating to lease computer equipment. The manufacturer is willing to lease to you, provided you put a security deposit into escrow. How should thc inclusion of a security deposit affect the equilibrium rental rate?
2.
You are leasing office space to a tenant of questionable credit quality. While you set a rental rate that is near the level of your safer tenants, you demand
336
s.R.
Grenadier/Journal ()]' Financial Economics 42
(1996)
333~64
that some of the future rent payments be made upfront. How many months' prepaid rent can you demand in equilibrium?
3. As an issuer of assetbacked securities, you bundle lease contracts. You are seeking an insurer to provide credit enhancement so that the securities can
obtain a AAA rating.
How much should you pay for such insurance?
The first contract provision 1 analyze is the security deposit requirement. Security deposits are very common on leases of capital equipment. As stated in Schallheim (1994), 'thirdparty guarantees and the pledging of other assets can be the difference between approval to lease and no credit approval'. Security deposits lead to a lessening (although not necessarily a complete removal) of credit risk. Of course, in return the contracted lease payment must be lower. The second contract provision I analyze is the requirement of prepaid rent. For example+ it is quite common in the rental of residential property for the first and last months' rent to be paid in advance. In fact, in many leasing contracts substantial prepayment of rent is required in order to lessen the potential losses of default. In return, the rental rate on the lease is lowered. The third application of the model is the valuation of lease credit insurance and guarantees. Such insurance provides payments to the lessor in the event of default. For example, in the leasing of commercial real estate space, the land lord may require the purchase of a thirdparty guarantee of the promised rental payments for the full term of the lease. Such guarantees are sought for small or newly established tenants. In addition, such insurance exists in the form of credit enhancement on leasebacked securities. Similar to other assetbacked securities, leasebacked securities can involve full or partial insurance against credit loss in the form of credit enhancement provisions. The fourth application of the model deals with valuing options to purchase the asset under conditions of default risk. Many leases contain an option for the lessee to purchase the underlying asset for a fixed price at the end of the lease term. Such options clearly have value, and of course affect the equilibrium rental rate. McConnell and Schallheim (1983) provide a detailed analysis of the option to purchase. The option to purchase helps align the incentives of the lessee and lessor. The option provides an incentive to the lessee to maintain the asset and to make the required rental payments. Should default occur, the lessee loses all rights to a potentially valuable option. The model is used to value this option to purchase in an cnvironment of credit risk. The final application is an analysis of percentage leases, the prevailing form of shopping center lease. In the U.S., shopping centers contain over 4.5 billion square feet and account for over $700 billion of retail sales (Shopping Center Directions, 1992). Percentage leases are indexed to a store's sales, so that the landlord shares a portion of the tenant's success. These sharing arrangements are especially pronounced for the smaller mall tenants. Thus, the impact of credit risk is likely to be sizable.
S. R. Grenadier / Journal ~[" Financial Economics 42 (1996)
333 364
337
In a more general equilibrium setting, such factors as the specific terms of the lease contract and the default propensity of the lessee will be determined endogenously. However, the valuation approach developed in this paper will serve as an essential component of the associated general equilibrium problem. For example, while the default boundary is likely to be chosen as part of a lessee's optimization problem, the equilibrium lease rate will be determined by the present model's formulation, contingent on the resulting optimal default boundary, In the oneperiod model of Lewis and Schallheim (1992), both the lease rate and the default probability are detennined endogenously. More generally, the type of contract chosen should be the one that is most efficient in terms of minimizing monitoring costs, adverse selection, moral hazard, transactions costs, and other factors related to the problems of contracting between lessees and lessors. Smith and Wakeman (1985) provide a unified analysis of how the existence of various incentive issues explain the use of distinct contractual provisions found in leases. However, contingent on the chosen contract type, the present model provides the equilibrium lease value and rental rate. The paper proceeds as follows. Section 2 develops the model of equilibrium leasing under conditions of credit risk. Section 3 analyzes the equilibrium lease credit spread. Section 4 characterizes the equilibrium security deposit provision. Section 5 analyzes the prepayment clause in risky leases. Section 6 analyzes lease default insurance. Section 7 provides an analysis of lease purchase options. Section 8 analyzes percentage leases, and Section 9 concludes.
2. The basic model
In this section, I provide an equilibrium determination of lease rates when the lease payments are subject to credit risk. Under a lease arrangement, the lessor sells the use of the asset for a specified period of time, and the lessee promises to make specified lease payments over the lease term. In equilibrium, the promised lease payment is set so as to compensate the lessor for both the forgone use of the asset and the potential consequences of default. There are two sources of uncertainty. First, the service flow of the leased asset (and hence its value) is stochastic. Second, the timing and consequences of default are also stochastic. The equilibrium lease valuation will take these factors into account. The solution approach will be that of optionpricing analysis. Traditionally, in the optionpricing literature, prices of contingent claims are based on arbitrage arguments. However, such an approach requires assumptions about the liquidity of the underlying asset. In the case of leasing markets, where the underlying assets such as office buildings and heavy equipment are subject to substantial transactions costs, indivisibility, and the inability to be sold short, such arbitrage arguments are particularly questionable. An equilibrium approach relaxes the tradability assumptions needed for arbitrage pricing, although an appropriate
338 S. R. Grenadier / Journal o! Financial Economics 42 (1996)
333 364
equilibrium model must be chosen. For simplicity, I assume risk neutrality, so that all assets are priced to yield an expected rate of return equal to the riskfree rate, r. This seemingly restrictive assumption can be relaxed by adjusting the drift rates to account for a risk premium in the manner of Cox and Ross (1976). The underlying demand for the use of the leased asset results from the value of its use as an input in economic activity. Let the value of the service flow from the asset be denoted by S(t), where S(t) evolves as the following diffusion process:
dS = ~.,.(S,t)Sdt + cr,(S,t)Sdz,. ,
(1)
where :~(S,t) is the instantaneous conditional expected percentage change in S per unit time, ¢,.(S, t) is the instantaneous conditional standard deviation per unit time, and dz,. is the increment of a standard Wiener process. The sign of the expected growth rate, :¢s(S,t), is not restricted. Thus, the service flow from an asset may appreciate or depreciate over time. Initially, consider the simple case of a Tyear lease to a riskless lessee. This represents the sale of the use of the asset for T years in return for a sure payment
can be
flow of R(T). The value of the use of the asset for T years, expressed as follows:
Y(S, T),
Y(S, T)
=
E
(//)
errS(t)dt
.
(2)
As in many models of risky bond pricing (e.g., Merton, 1974; Black and Cox, 1976; Leland, 1994), I assume that a riskless asset exists that pays a constant rate of interest, r. This simplification permits us to focus on the credit risk aspects of leasing directly. To extend the model to a stochastic interest rate environment, a term structure model (e.g., Cox, Ingersoll, and Ross, 1985; Vasicek, 1977) must be appended to the asset valuation model. 2 The equilibrium riskless lease rate, R(T), will then be the payment flow' whose annuity value equals g(& T). Thns, R(T) must satisfy the following equilibrium equality:
R(T)
(r)y(s,T) 1 e ,r
"
(3)
The value of the asset is simply the present value of the service flow of the
asset. The value of the underlying asset,
V(S)=
lim
Y(&T).
V(S), is then the perpetuity value of S(t):
(4)
2An extension of the present model to accomodate stochastic interest rates could be accomplished in a manner similar to Brcnnan and Schwartz (1980) and Kiln, Ramaswamy, and Sundaresan (1993). Using numerical solution techniques, they find that the yield spreads between corporate and Treasury bonds are quite insensitive to interest rate uncertainty.
S. R, Grenadier/Journal o! Financial Economics 42 (1996)
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339
Now consider a Tyear lease when the lessee is subject to the risk of default. While the lessee may pay the promised rental rate P(T) over the entire lease period, there is also the possibility that the promised payment is not realized. Lease default is contractually defined, and may consist of late payments, failure to maintain the asset, or failure to fulfill the covenants of other financial con
tracts. The causes of default are also varied. Business failure, liquidity crises, and dissatisfaction with the performance of the leased asset may underlie the failure to uphold the terms of the lease. Lease default may be broken down into two parts: the occurrence of default and the consequences of default. To model the occurrence of default, I follow Black and Cox (1976), Leland (1994), and Longstaff and Schwartz (1995) by assuming that default occurs when a financial state variable of the lessee, such as cash flow or asset value, falls to a lower threshold K. This definition of default is consistent with both the case in which the lessee is insolvent because it does not generate sufficient cash flow to meet current obligations, as well as the case in which the lessee's assets violate minimum net worth or workingcapital requirements. Such a default condition can thus account for both flowbased and stockbased insolvency, as discussed in Wruck (1990) and Kim, Ramaswamy, and Sundaresan (1993). Other similar approaches to modeling the occurrence of default are displayed in Merton (1974), Duffle and Singleton (1995), and Jarrow and Tumbull (1995). Let X(t) denote a state variable of the lessee, such as cash flow or asset value. If X(t) falls to the boundary K, the lessee defaults. This could represent late or missed payments, or outright abrogation of the lease. Thus, default occurs on a
Tyear
T. Mathematically, default occurs at time t* where t* = inf[t < T:X(t)<~K], where t* = .~c if no such t exists. Assume that X(t) follows a diffusion process that is correlated with the value of the leased asset as follows:
lease
if the
first passage
time
of X(t)
to
the
boundary
K
is
less than
dX = ~,,(X, t)Xdt + ~,.(X, t)Xdzs ,
(5)
where :zx(X, t) is the instantaneous conditional expected percentage change in X
per unit time,
time, and dzx is the increment of a standard Wiener process. Let p(S,X, t) denote the instantaneous correlation coefficient between the Wiener processes dz~. and dz~. If p is positive, then default is most likely to occur when the value of the asset is the lowest, and the consequences of default are the most severe. If p is negative, default is most likely to occur when the asset value is the highest, and the consequences of default are the lowest (i.e., the asset can be released at high rates).
a.,(X, t) is the instantaneous conditional standard deviation per unit
This definition of the occurrence of default is consistent with Hull and White's (1995) more general modeling of default. Hull and White assume that default occurs at the first time, t, when G(4),t)  0 for some function G, where q5 is
340
S.R.
Grenadier~Journal o1' Financial Economics 42 (1996)
333 364
a vector of state variables determining the occurrence of default. By allowing
4) = X//K and G ln(~), the
general model. Now that the event of default is defined, 1 model the consequences of default. Once again, the consequences and remedies depend on the terms of the lease. The lessor may sell the asset, demand payment of all future lease payments, or release the asset. The underlying asset may be damaged due to neglect, and the likelihood of recovering damages may be low. There also are likely to be losses
due to delay, legal costs, and brokerage and marketing costs. If default occurs at time t*, and if the asset could be fully recovered and immediately released, the
To model the costs of
default, I assume that the lessor is only able to receive a fraction, 1 {,~, of this
remaining lease value, where ~ q [0, 1]. Nielsen, SafiRequejo, and SantaClara (1993), Leland (1994), and Longstaff and Schwartz (1995) also assume a proportional loss in their models of bond default. The payoffs to claimants in the event of default depend on a host of exogenous factors, most importantly the bargaining power of interested parties. One may consider c~) as the outcome to a bargaining process. Although I treat ~o as a constant, this framework could easily be generalized to allow for stochastic values of a). Because co enters the payoff" function linearly, only its expectation matters. Thus, one can simply interpret ~o as the expected value of the loss due to default. To derive the equilibrium rent on a risky Tyear lease, P(T), I once again use the underlying concept of equilibrium: any two methods of selling the service flow of the asset for T years must have the same value. Consider the following two alternative methods of selling the service flow for T years.
remaining value of the lease would be Y[S(t*), T  t*].
present
model
is
a
special
case
of their
more
Alternative 
1: 
Lease the asset for T years 
to a lessee 
fi'ee of credit risk. 
The 

value of this alternative 
is 
Y(S, T). 

Alternative 2: 
Lease 
the 
asset under 
a Tyear 
lease 
to 
a risky 
lessee, 
at 
the 

rental rate P(T). 
If the event of default occurs at time 
t 
< 
T, lease the asset out 
for the 
remainder of the 
term 
(T 
t) 
to 
a riskless lessee. 
Due 
to 
the 
costs 

of default, 
however, 
the 
lessee 
is 
only 
able 
to recover a fraction 
1 ,) 
of 

Y[s(t), 
r 
 
t]. 
1 now derive the value of Alternative 2. In equilibrium, P(T) is set at the outset
of the lease such the values of Alternatives
denote the value of Alternative 2, where t is the current time and S and X are the current values of S(t) and X(t), respectively. Let P be a given rent rate (to be determined in equilibrium). Consider the instantaneous return on F over a region in which the lessee has not yet defaulted: X(v) > K, Vv~<t. By It6's lemma, the instantaneous change
1
and 2 are equal.
Let F(S,X, t; P, T)
in
S.R. Grenadier/JourmH of Financial Economics 42 (1996) 333364
341
F
is
dF =
c~(S,t)S Fss +p(S,X,t)c~.(S,t)c(~(X,t)SXFsx
+ 5c;~(X,t)X2Fxx + ~(S,t)SFs + ex(X,t)XFx + Ft dt
+ ~s(S, t)SFsdz, + ax(X, t)XFxdzx.
12
]
(6)
In addition to the capital gain received on this lease, the lessor receives a cash
inflow due to the rents of Pdt. time, /~f, is defined as 
Therefore, the total expected return on F 
per unit 

I~Fdt E [dF +FPdt] . 
(7) 

Setting the 
expected 
return 
equal to the equilibrium 
return 
r 
and simplifying 
yields the following
equilibrium partial differential equation:
0
1
a, (S, t)SZFss + p(S,X, t)a,(S, t)ax(X, t)SXFsx + ~ax(X, t)X2F~c¥
2
1
2
+~,(S, t)SFs + ex(X, t)XFy + F~ + P  
rF. 
(8) 

This partial 
differential 
equation 
is solved subject to boundary 
conditions 
de 
fined by Alternative 2. At the moment default occurs, when X(t) ~ K, the lessor
obtains
This default boundary condition
a fraction
of the value of the remaining
can be written as
lease,
(1

co)  Y[S(t),
T 
t].
F(S,K,t;P,T)
(9)
if no default occurs over the life of the lease, the terminal con
(1

co) Y[S(t),
T
t].
Alternatively,
at
maturity:
(10)
Now, by specifying the parameters of the stochastic processes for S(t) and X(t), [es(S,t),c~x(X,t),p(S,X,t)], we can solve partial differential equation (8) subject to boundary conditions (9) and (10). In general, closedform solutions will not be available. However, such equations can be solved using numerical techniques. Finally, to derive the equilibrium risky rent on a Tyear lease, I use the equilib rium condition that the values of Alternatives 1 and 2 must be equal. Therefore, the equilibrium rent on a Tyear lease subject to default risk, P(T), is set at time zero such that the following equality is satisfied:
(1 1)
I will now assume that S(t) and X(t) follow correlated geometric Brownian motions (jointly lognormal). Thus ~s(S,t), ccx(X,t), and p(S,X,t) are equal to
dition
ensures
that
the
value
O.
of the
remaining
rental
payments
equals
zero
F(S,X, T;P, T) ~
F(S,X,O;P(T), T) = Y(S, T).
342
S.R.
Grenadier/Journal o/ Financial
Economics 42 (1996)
333 364
the constants ,~,., ~,
the financial and realoptions literature. This will permit a closedform solution to be obtained.
and p, respectively. Such an assumption is very standard in
Under the correlated geometric Brownian motion assumption, the solution to Eq. (8) subject to boundary conditions (9) and (10) is
F(S X.t;P,T)
=
cPl(P,~)
(b2(X,z)
.+cb3(y,r).(1
P
r
(o)
r
S
fZs
(12)
where z 
in the Appendix. The value of Alternative 2, F(S,X, t;P, T), while complex, is quite easily in terpreted. The first term, @l(P,z), is equal to the value of the rental flow if the lease is riskfree. The second term, q~2(X,r) (P/r), is the value of the potential loss of all contracted rentals if the lessee defaults. The third term, q~3(X,r). (1 v))(S//(r ~s)), is the value of the rent that is recovered should the lessee default. Therefore, the total value to leasing the asset according to Alternative 2 is equal to a portfolio consisting of (i) a riskless lease, (ii) a short position in a contract which pays out the credit loss under a lease, and (iii) a long position in a contract which pays the amount recovered from a lease default. By applying the solution to the lognormal case derived in Eq. (12) and in the Appendix to the equilibrium rent equation, Eq. (11), the equilibrium rent on a lease subject to credit risk is
T
t, and the functions q51(P,r), qO2(X, 2"), and 4~3(X,r) are presented
p(T)=
r.S
(~)[1

e
(r
@3(X,T).(I
] 7 7 7Y7 ~2(~~k ~
~,)r
(,0)]
_{]}
_{'}
(13)
3.
Analysis
of the
lease
credit
risk spread
rents
indifference relative to a lessee with no credit risk. The credit risk spread, D(T),
is defined as P(T)
the size of the cushion demanded on risky leases.
Lessors
of assets
will
R(T).
adjust
the
charged
to
a risky
lessee
to
ensure
In this section,
I analyze the factors that
influence
In essence,
this
analysis
is analogous
to
the
study
of the
risk
structure
of
interest rates. In Merton (1974), the comparative statics of the difference between
the yield on a defaultable bond and a riskless bond are derived. Unlike the case
of the bond, which 
is essentially the 
sale 
of 
a lump sum of cash in return 
for 

a series 
of future 
cash 
flows, 
a lease 
is 
the 
sale 
of the 
economic benefits of 
a specific asset. Thus, the lease credit risk spread will be related to variables
underlying the processes of both the lessee's firm value and the leased asset, as well as numerous contractual provisions.
S.R. Grenadier/Journal
o1' Financial Economics 42 (1996) 333 364
343
When S and X are correlated geometric Brownian motions, a closedform
Subtracting Eq. (13)
from the solution to Eq. (3) provided in the Appendix, the credit risk spread can be written as
solution for the equilibrium
credit spread can be derived.
D(T) =
~
1 
e'r

qO2(X,T)
i~e
r~
J
"
(14)
The impact of various parameter changes on the credit risk spread are illustrated in Figs. la through lf. 3 Fig. la plots the impact of lease maturity (T) on the spread, In essence, this is a plot of the term structure of lease credit spreads. The term structure of lease credit spreads is upwardsloping. That is, for longerterm leases, the premium that a risky tenant must pay relative to a riskless tenant increases. The intuition is simple: the longer the term, the greater the likelihood of default. Since the lessor recognizes this at the outset, the rent must compensate for the higher expected losses. Consider the empirical implications of this result for the leasing of real estate. For the leasing of residential space, shortterm leases are standard with the vast majority of lease terms in the range of one month to one year. However, for the leasing of office space, longerterm leases are standard, typically in the range of three to ten years (DiPasquale and Wheaton, 1996). Therefore, the model would predict that risky office tenants will be charged a greater rent premium than risky apartment tenants. In addition, the concavity of the term structure of lease credit spreads suggests that for longterm leases, the premium required to compensate for risk moderates. Fig. lb plots the impact of the fraction of the lease value lost in default ((~J) on the spread. The spread is increasing and linear in {o, as is readily apparent from Eq. (14). This is as expected, since the impact of default is more detrimental the greater is (u. There are several empirical implications. For example, if the lessor has greater negotiating power than the lessee (say, due to firm size or resources), then (,) (or similarly the expected value of ~o) is likely to be lower. This would imply that, all else equal, larger lessors can charge lower credit spreads than smaller lessors. In addition, (fo is likely to depend on the number of other creditors of the lessee. If the lessee defaults on the lease, it is also likely to
3While the results here are derived under a base case set of initial parameter values, they hold under
a wide variety of realistic paraineter values. However, it is important to note that for significantly
negative values of p, and relatively sale leases (high X/K), the credit spread can actually become negative. That is, one might theoretically charge a lower rent for a lessee subject to default than for
a 
lessee with no credit risk. The key to this surprising result is in the negative correlation. Default 
is 
most likely to occur when the asset can be released at unexpectedly high values, potentially even 
great enough to compensate for the fraction of the service flow, {o, lost in default. The conditions under which this result obtains are unlikely to be observed in actual leasing markets.
7'year lease subject 
to 
credit 
risk 
and that 
charged 
on 
a riskless Tyear lease. 
The 
lease 
credit 

spread is derived 
in Eq. (14). 
The 
six graphs in the ligurc show the effect of chauges in the 
under 

lying 
parameter values 
on the 
equilibrium credit 
spread. 
Fig. 
la shows 
the effect of increasing T, 

the 
term of the 
lease. 
Fig. 
lb 
shows 
the effect 
of increasing ~o, the proportion of the 
lease 
value 

lost 
in the event 
of default. 
Fig. 
lc shows 
the 
effect 
of 
increasing the 
ratio 
of 
the lessee's 
asset 
value to the default trigger, X/'K: tile closer the ratio is to one,
the greater the likelihood of default.
Fig. 
ld 
shows 
the effect of the correlation, p, between 
the leased asset value 
and the lessee's 
asset 

value. 
Fig. 
le 
shows 
the 
elt;ect of the volatility 
of the 
leased 
asset, 
o~, for different values 
of the 

correlation coefficient. 
Fig. 
If shows the effect of the volatility of the 
lessee's 
asset value, cry. The 
default parameter 
values are 
:q 
O, 
~v 
 
0.02, 
o~  
0.15, 
o2, 
0.15, 
p 
 
0.5, 
r 
0.05, u) 
0.2, 

T 
 
5, 
S 
10, 
and X,,'K  
1.2. 
s[R. Gretuutier/ Journal o! Financial Economics 42 (1996) 333~64
345
default on its other financial obligations. Thus, the priority of the claims, and the relative bargaining power of the associated claimants, will determine the expected magnitude of c,). All else equal, the lease rate should be higher the greater the number of fixed obligations of the lessee. Fig. lc plots the impact of the ratio of the lessee's asset value (or cash flow) to default trigger (X/K). Notice from Eq. (14) that the variables X and K affect D(T) only through the ratio X/K. Thus, this ratio, combined with the stochastic properties of X(t), serves to define the likelihood of default. As one would ex pect, the credit spread is decreasing in the ratio X/'K. The higher the ratio, the lower the likelihood of default during the lease term. As X/K increases, the credit spread falls to zero and the risky lease rate approaches that of a riskfree lease. In addition, the spread is convex in the ratio ~,"K. This suggests that the spread in creases rapidly as the lessee's default probability increases. The implication is that while there may be little difference in the rent premium charged to AAA lessees and AA lessees, there will be a significant premium charged to 'junk' tenants. Fig. ld plots the impact of the correlation (p) between the lessee's finn value and the underlying asset on the spread. The spread is increasing in the correlation. The greater the correlation, the worse the anticipated impact of default. A higher correlation means that when the firm's assets fall enough in value to trigger default, it is more likely that the underlying asset (and the lease's value) will be low. Since higher correlation magnifies the impact of default, the spread is widened. This result has important empirical implications. It suggests that the spread charged to lessees will depend on how movements in the lessee's cash flows are correlated with movements in the underlying leased asset's value. This could mean that the industry of the lessee will matter in setting the lease term. For example, consider two lessees from different industries who sign leases tbr the same asset, under the same terms, and with identical default probabilities. The firm whosc fortunes arc most correlated with the value of the undcrlying asset will pay a higher rent. This would imply, for instance, that the rent charged to an airline for leasing an aircraft would be higher than that charged for a comparably risky operating company (in an industry unrelated to the aircraft industry) that is leasing the aircraft for its corporate fleet. Similarly, the rents charged to tenants in a shopping mall will vary according to the correlation of the sales of an individual store with the sales of the mall as a whole. All else equal, a mall shop whose sales possess low or negative correlation with the sales of the other stores in the mall should pay a lower rent. Fig. le plots the impact of the volatility of the underlying asset (or,) on the
spread. Simulations rcvcal that the effect depends on the sign of p. If p is positive,
the spread is increasing in r~,
intuition is as follows. If p is
positive, the event of del;ault is likely to occur when the underlying asset value is depressed. If cr~ is high, there is a greater likelihood of unusually low recovery values. Thus, the spread must be high. Conversely, if p is negative, the event of
If
p
is negative, the spread is decreasing in rT,
The
If /) is zero, the spread is constant in r;,
346 s. R.
Grenadier/Journal ~[ Financial Economies 42 (1996) 333 364
default is likely to occur when the underlying asset value is unexpectedly high.
With high a~, there is a greater likelihood of unusually high recovery values. Thus, the spread will be low. When p is zero, the event of default is uncorrelated with recovery values; the increased volatility is not priced.
state variable
(~x) on the spread. The spread is increasing in ax. For any initial level of X, the expected time of default is nondecreasing in ax. Because the lessor prefers to avoid the consequences of lease default, the spread must be set high enough to compensate for such risk. This would imply that lessees with lower cash flow or asset volatility will be charged lower rents, all else held constant. For example, firms with divisions in diversified lines of businesses may pay lower rents than more concentrated firms.
Fig.
If plots the impact of the volatility of the lessee's financial
4. The equilibrium security deposit
Many realworld lease contracts contain clauses that provide some form of
protection to the lessor against lessee default. A very common clause in leases
is for the payment of a security deposit. A security deposit can take a variety
of forms. The lease could require the lessee to place funds in escrow as security against default or require a letter of credit from a third party. Alternatively, the lessee may be required to pledge personal assets as collateral in the event of default. All of these methods lead to a lessening (although not necessarily
a complete removal) of credit risk. Of course, in return the contracted lease
payment must be lower. The model permits a determination of the equilibrium lease rate on a lease with
a security deposit clause. Consider the following lease arrangement. A lessee and
lessor agree to a Tyear lease with a security deposit of SM. In addition, they agree on a rental rate of PJ(T,M). The goal of this section is determining the level of rent, Y(T,M), that is consistent with the security deposit arrangement. It is important to emphasize that the inclusion of the security deposit clause will provide an incentive for the lessee not to default. Therefore, the default boundary K is likely to be lower for a firm faced with a security deposit clause. Thus, K should be considered as endogenous to the contractual provisions. While the present model does not explicitly model the effect on the firm's default incen tives, the model holds true provided we interpret K as the outcome of a lessee's optimization problem. A similar story can be told with regard to the parameter at, the volatility of the lessee's assets or cash flow. With a security deposit pro vision, the firm has an incentive to lessen the volatility of its other assets, thus making default less likely. Once again, one should interpret ~x as the outcome of a lessee's optimization problem. Consider the following simple security deposit clause. The lease stipulates that
a fixed amount, M, must be deposited in escrow as a security deposit. The
s.R. Gremtdier/ Journal ~1'Fimmcial Economics 42 (l 996) 333 364
347
deposit accrues interest at the rate r. If the lessee does not default, then the
security deposit reverts back to the lessee. However, if the lessee defaults at any time t < T, then the lessor can use the deposit to help compensate for potential credit losses. Recall that if t* is the moment of default, then the lessor suffers a credit loss
of o9. 
Y[S(t*), T  t*]. Now, with the security deposit, the lessor has access to 
Me r~* 
in the event of default. Therefore, if t* < T is the moment of default, the 
total payoff to the lessor at time t* under this leasing arrangement is
(I ,,9).
Y[S(t*),
Tt*]
+Me r'*
The payoff in the event of default, Eq. (15), can be separated into three com ponents. The first term is simply the payoff upon default on a standard lease with no security deposit, just as in the basic model. The second term is the payoff from investing $M in zerocoupon bonds with stochastic maturity t*. The final term is the payoff from a put option on the credit loss, with exercise price Me '<and stochastic expiration date t*. Denote the value of the cash flows from leasing under this arrangement as W(S,X,t;P l~, KM). As in the basic model, the value must satisfy the following partial differential equation in equilibrium:
0~ ~a~(S,
)S'~'%. + p(S,X,t)¢,.(S,t)a,.(X,t)SXWs.x
+ ~r;(X,t)XZWxx
+:~,.(S,t)SWs + ~,,(X,t )XWx + )~t + pD _ rW,
subject to the boundary conditions:
W(S,X,T;P~),T,M)
O,
Y[S(O, rt] +Me"

max {Me',o.
YIS(t),
Tt],
0},
(16)
(17)
where the first boundary condition signifies the end of the lease term and the second represents the payoff in the event of default, as characterized by Eq. (15). Finally, two methods of selling the use of the asset for T years must have the same value in equilibrium. Thus, the equilibrium rent, Pn(T,M), must be set at time zero such that the value of the lease with the security deposit equals the value of a lease without a security deposit. Therefore, pD(T,M) must be the solution to the following equality:
F(S,X,O;P(T),T)
W(S,X, O;PD(T,M),T,M).
(18)
348 X R. Grenadier~Journal oj Financial Economics 42 (1996) 333 364
Equilibrium Rent
12
11
_{1}_{0}
I 
I 
I 
I 

0 
2 
4 
6 
8 
Deposit
Fig. 2. The effect of security deposit on equilibrium rent.
This graph shows thc equilibriuln rent on a risky fiveyear lease as the amount of the security deposit increases. A security deposit represents funds placed into escrow by the lessee to cover potcntial losses incurred in the event of default. A security deposit serves to mitigate the impact of credit risk. [f the risky Icase requires no security deposit, then the equilibrium rent is $11.50. If a $5 security deposit is required, thcn the equilibrium rent falls to $10.60. The def:ault parameter values are ~, = 0, ~,  0.02, a., 0.15, a,.  0.15, p  0.5, r 0.05, ~o  0.2, T 5, S 10, and X/K 1.2.
In the Appendix, a solution for W(S,X,o;pD, T,M) is derived for the case in which S and X evolve as correlated geometric Brownian motions. Combined with the solution for F(S,X,t;P,T), the equilibrium solution for PZ)(T,M) can be derived. Fig. 2 plots the equilibrium lease rate as a function of the security deposit. On a fiveyear lease, the rent falls from $11.50 with no security deposit to $10.60 with a $5 security deposit. In equilibrium, there will be an infinite number of combinations of rent and security deposit that leave the parties indifferent. Of course, the precise combination chosen should be efficient in that it minimizes the costs of factors such as adverse selection, moral hazard, credit verification, and monitoring.
5. The equilibrium prepayment clause in risky leases
Another form of protection against credit risk is a prepayment clause. A very common clause in leases requires the lessee to make one or more payments in advance. As noted by Schallheim (1994), ahnost all leases demand some form of prepayment, but the amount will vary according to the degree of credit risk. Prepayments in the range of one to six months in advance are quite common.
S.R. GrenadierIJournal of Financial Economics 42 (1996) 333364
349
According to the contract, if the lessee pays n months' rent in advance, the final n months of the lease are rentfree. Prepayments provide protection to the lessor, and in return the lessee must receive a lower lease rate. For any given contract rent, the model can be used to determine the equilibrium fraction of the lease that should be prepaid. For example, consider a Tyear risky lease. Suppose that the lessor charges the risk free rental rate of R(T) or, similarly, any rent payment less than the equilibrium rent P(T). In addition, a prepayment of 6 years is required in advance. Thus, the lessor receives an upfront payment of 6 •R(T). The question is, how much should the prepayment period 6 be? To determine the equilibrium prepayment period, I once again use the argument that any two methods of selling the service flow of an asset for T years should have the same value. The first alternative is to simply lease the asset for T years to a riskless tenant. By collecting a rent flow of R(T), this alternative has a value of Y(S, T). The second alternative is to lease to a risky tenant for T years, charge the rent R(T), and collect an upfront security deposit of 6 years rent, 6 •R(T). If the lessee makes all payments up to time T 6, then the lessee retains use of the asset for the remainder of the term and makes no rent payments. If the lessee defaults at any time t < T 6, then the lessor releases the equipment (after suffering a default loss of the fraction w of the remaining lease value) to a riskless tenant for the remainder of the term. Since both leasing alternatives sell the asset's use for precisely T years, each must have the same value. The value of the riskless lease is simply Y(S, T). The value of the second alternative is only a slight transformation of Alternative 2 in Section 2 of the paper. Consider a (T+ 7~)year riskly lease with a rental payment flow of P for the first T years, and no required rent for the final i? years. Denote the value of this lease by 15(S,X, t;P, T, T). t~(S,X,t;P, T, T) will solve the same differential equation as F(S,X, t; P, T), with the exception that the righthand side of boundary condition (9) will be (1  o)). Y[S(t), T + T  t]. Since the second alternative is equivalent to an upfront payment of 6. R(T) plus a risky lease with a term of T years with lease payments of R(T) paid for the first T 6 years only, its initial value can be written as 6 • R(T) + F(S, X, 0; R(T), T  6, 6). Using this equilibrium relation condition, the equilibrium prepayment, 6", is set such that the value of the alternatives are equal. This value of 6" satisfies the following equality:
Y(S,T)
6*.R(T)+F(S,X,O;R(T),T
6~,6").
(19)
Under the assumption that S and X follow correlated geometric Brownian motions, a closedform solution for F(S,X,t;P, T, T) is obtained. F will have a solution identical to that of F in Eq. (32) of the Appendix, with the sole excep
tion that ¢bs(X.z) will now equal (X/K)C2G(X,z, a4) e(r~')(T+T)G(X,z, a3).
Fig. 3 plots the effect of increasing credit risk on the equilibrium prepayment
lessee to become decreasingly risky by
period.
In this
figure,
I allow
for the
_{3}_{5}_{0} S. R. Grenadier~Journal o1"Financial Economics 42 (1996) 333364
Equilibrium
Prepayment Period
3 yrs.
2
yrs.
1yrs.
"~
•,
":
'%
',
".°
% ""
"'.
•
•
ox = .25
: 
" 
~× 
=.15 
""" 

' 
c~x 
= .05 
"'. 
0 yrs.
' 
I. 
I 
I 
1 
1.25 
1.5 
1.75 
2 
X/K
Fig. 3. The effect of credit risk on the equilibrium prepayment period.
This graph shows the equilibrium period of rent which must be prepaid on a risky fiveyear lease,
as the lessee's initial credit position varies. On this lease, a riskless rent is charged, plus the lessor
trigger,
X/K, rises, the lessee's likelihood of default falls: if X/Kl,
X/K ~ oc, the lease is riskless. For lessees on the brink of default, a significant portion of the lease must be prepaid. For lessees far from the default boundary, almost no prepayment is required. This effect is demonstrated for three different levels of the lessee's volatility, ~r~. The greater the uncertainty of the lessee's ability to make the future lease payments, the greater the required prepayment period. The default parameter values are ~s.  0, ~x  0.02, ~.  0.15, p  0.5, r 0.05, co 0.2, T = 5, and S 10.
if
demands
a period
of prepaid
rent.
As the
ratio
of the
lessee's
asset value to the default
the lessee will default immediately;
raising the ratio X/K from just above unity (at which default occurs immedi ately) to levels at which default becomes virtually impossible. For leases on the threshold of default, a significant portion of the payments on a fiveyear lease are required upfront in order to justify charging the riskless rent. For lessees far from the default boundary, almost no prepayment is required. In addition, the convexity of the curve suggests that the prepayment period is most sensi tive for lessees with high credit risk. This would suggest that variations across prepayment periods should be more pronounced with lessees approaching 'junk' quality credit ratings. In addition, as the volatility of the lessee (ax) increases, the required prepayment period increases.
6.
The
valuation
of
lease
credit
insurance
and
guarantees
Many types of insurance are available for lease transactions. One particular form of insurance that provides a direct means of eliminating or lessening default risk is credit insurance. Lease credit insurance protects the lessor, partially or
S.R.
Grenadier~Journal o1' Financial Economics 42 (1996)
333 364
351
wholly, against the loss of payments due to default. Although such protection is available in a variety of forms, I focus on two specific examples of lease credit insurance: real estate lease guarantees and credit enhancement provisions of leasebacked securities. When a landlord negotiates a lease of commercial space with a small or newly established tenant, a lease guarantee can be included as an addendum to the lease. Although the underlying lease is an agreement between the land lord and tenant, the guarantee will be between the landlord and a third party. The third party (the guarantor) will personally guarantee the rent payments for the full term of the lease (Wolfson, 1992). A typical provision will state: 'The guarantor unconditionally and without reservation guarantees that the tenant will faithfully and punctually perform and fulfill all its obligations, covenants, and agreements of the lease. In the event the tenant defaults, then the guarantor guarantees to pay rent and all other monetary sums due to the landlord.' Lease credit insurance is important in a recent, but growing area of financial markets: leasebacked securities (LBS). LBS are similar to standard assetbacked securities contracts. A pool of leases is bundled and then sold to investors. The first such securities were issued by Sperry Corporation in 1985. The volume of such issuances has been growing rapidly. In 1992, Duff & Phelps Credit Rating Company alone rated $690 million of LBS. In 1993, the number increased to just under $900 million. While few of the issuances have been public, a steady flow of transactions has been issued by small and midsized leasing companies in the privateplacement market. Similar to other assetbacked securities, LBS can involve insurance against credit loss in the form of creditenhancement provi sions. This insurance against default may be full or partial. The method of credit enhancement may take a variety of forms: overcollateralization, cash reserves, or letters of credit. Thus, while the underlying leases in the pool are subject to default risk, the securities themselves may be defaultfree. The equilibrium lease model in this paper can be applied to an analysis of credit insurance. Consider a Tyear risky lease written at the equilibrium rent P(T), as defined by Eq. (11). The lessor securitizes the lease and purchases in surance to improve the security's credit rating. The insurance contract promises that, should the lessee default at time t*, the investor is guaranteed a payoff of at least a fraction ,' of the promised value of the remaining lease payments, P(T)(1 e ,.qr ~x/)/,r. Since the amount recovered on the underlying lease is (1 (o)Y[S(/*), Tt*], the investor is assured of receiving the greater of (1 ~o)Y[S(t~), T 1"] and 7.P(T)(1 e"cr'*l)"r,,. For this example, assume that the insurer's obligation is without risk. Let 7*(& X,t; K 7) denote the value of this insurance contract. It must solve the following partial differential equation:
0
I
2
c,~(S, t)S
2
7'ss + f~(S,x, t )o~(S, t)ox(x, t )SXq'sx + ~or;(x, t)x ~vx
I
"~
"~
+z~,,(S,t)SCPs + ~,(X,t)Xq~x + ~P,
riP,
(20)
352 S, R. Grenadier / Journal of Financial Economics 42 (1996) 333~.364
Value of Insurance Contract
40
30
20
10
=
.85
~
~
,/= 1
I,
1.125
I
1.25
I,
1.375
I
1.5
X/K
Fig. 4. The equilibrium value of credit risk insurance.
This figure shows the effect of changes in the level of insurance (7) and the current distance t:¢om default (X/K) on the value of a credit risk insurance policy. A credit risk insurance policy promises the holder of the lease a payout of at least a fraction ?, of the value of the remaining contractual lease payments. Three curves plot the effect of increasing distance from default on the equilibrium insurance premium: the lop curve is for a fully insured contract, the middle curve is for a contract promising 85% coverage, and the bottom curve is for a contract promising 70% coverage. For each level of insurance 7,, increasing the distance from default leads to a decrease in the insurance premium. However, the difference in pricing is only significant for the most risky leases. The default parameter values are ~,. 0, c~ = 0.02, ~r~. = 0.15, aa 0.15, p = 0.5, r = 0.05, co = 0.2, T = 5, and S=IO.
subject to the boundary conditions
,v(s,x,
T;
T,
?,)
~(S,K,t;,T,?,)
=o,
=
max[)'Pt(T)(
1

e~(rt))

(1

~)v(s,
r
t),o
l
.
(21)
The first boundary condition ensures that the insurance payment is zero if there is no default. The second boundary condition is the insurance payment upon default:
the potential shortfall between the amount recovered and the promised minimum payout. The cost of this insurance policy is paid at time zero and must equal ~(S,X, 0; T,;,), the solution to partial differential equation (20) evaluated at t = O. For the case in which S and X evolve as correlated geometric Brownian motions, a
S.R. Grenadier/.hmrmd O/F#lancMI Economics 42 (1996) 333 364 
353 

solution is presented 
in the Appendix. 
This solution can be written 
as 

VJ(&X,0;7",7) 
B(&X;K0,7,1 
~,)), 
(22) 
where the fimction B(S,X; T, yl, Y2, Ys) is defined in the Appendix. Fig. 4 plots the effect of changes in the level of insurance (7) and the current distance frorn default (X/K) on the value of a credit risk insurance policy. Three curves plot the effect of increasing distance from default on the equilibrium in surance premium: the top curve is for a 100% fully insured contract (5, 1), the middle curve is for a contract promising 85% coverage, and the bottom curve is for a contract promising 70% covcragc. For each level of insurance 7, a greater distance from default leads to a decrease in the insurance premium. The premium is convex in X/K, meaning that the effect of increasing the degree of credit risk on the valuc of the insurance is most pronounced for very risky leases, in addi tion, the insurance premium increases with the level of insurance. However, the difference in pricing is only signilicant lbr the most risky leases. As A;/K reaches around 1.25, the effect of ;' is negligible.
7.
Credit risk and the option to purchase
A common clause in leases is fi)r the lessee to have the option to purchasc
thc asset at the end of the term of the lease for a predetermined price. Mc
Connell and Schallheim (1983) provide a valuation of this option. Because the granting of such options is valuable, the rental payments must be adjusted up wards.
In
the
context
of credit
risk,
these
purchase
options are especially relevant.
Because these options can be exercised only at the end of the term, the op tions provide an incentive lk)r thc lessee not to default on the lease. The in tensity of this incentive depends on the attractiveness of the predetermined ex ercise price, typically set at the expected value of the underlying asset at the
end of the lease term. From the viewpoint of the lessor, two lessees with equal
ex ante credit risk will likely have different ex post lease default realizations depending on whether they sign a lease with or without purchase options.
end
of the lease ['or the fixed exercise price of E. This differs fiom a standard call option in that the option may only be exercised should the lessee not dethult. The value of this option, H(S,X.I; T,E), will once again satisfy the following equilibrium partial differential equation:
Consider
the value
of an
option
to purchase
the
underlying
asset
at the
0 I
a7(5,1 ~ , )5"2tt~~, + p(S, A\ t )(r~(S, t)a,(X, t )SXHs.¥ + ~a~(X t) V~Hvv
~,.(S, t )Stts
~, (X, t)XHv
+
Ht

rH,
(23)
354 S. R. Grenadier~Journal of Financial Economics 42 (1996) 333364
Option Value
40
, 
E = 180 

 
iii 

:iil 
] 
E = 220 
0 
(5: 
I 
I 
I 
I 
1.25 
1.5 
1.75 
2 
X/K
Fig. 5. The effect of credit risk on a purchase option's value.
This graph shows the value of an option to purchase the underlying asset, as both the lessec's initial credit position and the exercise price varies• The option allows the lessee to purchase the underlying asset at the end of a fiveyear lease for a fixed exercisc price $E. This option may be exercised by the lessee only if there is no default during the term of the lease. The oppoortunity to exercise a potentially valuable option provides an incentive for the lessee to avoid default. The top curve plots the value of the purchasc option with an cxercise pricc of $180 as the distance from the default threshold increases. The middle curve is interpreted similarly, but with an exercise price of $200 (the expected terminal asset value), and the bottom curve has an exercise price of $220• The value of this option increases as thc exercise price falls and the probability of default declincs. As the ratio of the lessee's asset valuc to the default trigger, X/K, rises, the lessee's likelihood of default falls: if X/K  I, the lessee will default immediately; ifATK + oo, the lease becomes riskless. For lessees on the brink of default, the option is virtually worthless• For lessees l:ar from the default boundary, the option value is significant. The default parameter values are :q = 0, ~ = 0.02, a~ = 0.15, o~ = 0.15, #  0.5, r = 0.05, ~,)  0.2, 7'  5, and S = 10.
subject to the
boundary
conditions
H(S,X,T; 
T,E) 
= max [V(S) 
 
E, 
0] 
, 

H(S,K,g; 
T,E) 
= 
0, 
(24) 
where V(S) is the value of the underlying asset, as determined in Eq. (4). The
first boundary condition is the call option payoff at maturity. The second boundary
condition reflects the fact that the value of the option falls to zero if the lessee
defaults.
For the case in which S and X follow correlated geometric Brownian motions,
a closedform solution to partial differential equation (23) subject to boundary
conditions (24) and evaluated at time t = 0 is derived in the Appendix.
Fig. 5 plots the effect of the ratio of X/K on the value of the option to purchase
for different values of the exercise price E. Since the expected value of the asset at the end of the lease term is 200, the middle curve represents the typical protocol
of setting the option exercise price equal to the asset's expected terminal value.
S.R. Grenadier/Journal o[ Financial Economics 42 (1996) 333 364
355
For each value of E, the option price
the ratio is unity, the lessee is certain to default, and the option is worthless.
As the ratio rises, the probability of default falls to zero, and the value of the purchase option approaches the value of a standard 'nodefault' call option on the underlying asset. When the lessee's asset value (or cash flow) is reasonably far above the default trigger value, the standard 'nodefault' call option value will be a good approximation of the lease purchase option. However, when the lessee's credit condition is vulnerable, using a standard call option formula can be a very poor approximation. As the exercise price increases, the value of the option to purchase falls. When the lessee's credit condition is highly vulnerable, however, the effect of changes in the exercise price are quite moderate. This is because the likelihood of exercise, no matter how attractive the option, falls to zero due to impending default. In order to derive the equilibrium rent, P"(T), on a Tyear risky lease with
of the standard put call parity rela
a purchase option, we will use a variant
increases with the ratio of X/K. When
tion. It will prove useful to characterize the value of two additional contracts. First, consider an option to sell the leased asset at the end of the lease term, conditional on no default having occurred. This is simply a put option on the asset with exercise price E and expiration date T, conditional on no default. Denote the value of such a put option as J(S,X,t; KE). The value of this put option must satisfy an equilibrium partial differential equation, which is pro vided in the Appendix. Second, let N(X,t; T) denote the value of a zerocoupon bond which pays $1 at time T only if there is no default. The value of this
bond will satisfy an equilibrium partial differential equation, also provided in the Appendix. Now, we can determine the equilibrium rent, P~'(T), on a Tyear risky lease with a purchase option. As usual, I will present two equivalent methods of selling the use of the asset. The first method of selling the use of the asset is to simply
lease the asset for T years under a lease with
defaults, then the lessor releases the asset for the remainder of the term (after de
ducting a credit loss) to a riskless lessee. Under this leasing policy, the lessor sells
the use of the asset for
is exerciscd. The value of this portfolio is F[S,K,t;P°(T), T] H(S,X,t; KE).
The second method is for the lessor to form the following portfolio: sell thc use of the asset for T years by leasing to a riskless lessee, purchase E zero coupon bonds paying $1 at time T only if no default occurs, write an option to sell the asset at time T for $E where the option may only be exercised if no default occurs, and write an option to purchase the asset at time T for $0 where the option may only be exercised if no default occurs. The value of this portfolio is Y(S, T) + E,~(X,t; T) J(&X,t; T,E) J(S,X,t; K0). The payoff of this portfolio is precisely that of the first method: the lessor receives payments for selling the use of the asset for T years plus a payment of E V[S(T)] in year T if the option is exercised.
a purchase option. If the lessee
T years and receives E V[S(T)] in year T if the option
356 X R. Gremtdier/.lourna/ of Fimmcial Economics 42 (1996) 333 364
Since both of these methods of leasing produce identical payoffs, the lease rate p0(T) must bc set at time zero to cquate their values. Thus, in equilibrium P"(T) must be set to satisfy the following condition:
FiX, K, i; if'(r),
T]

H(S,X,
t; r, E)

Y(S,T)+EN(X,t;T)J(S,X,t;T,E)
J(S,X,t;T,O).
(25)
Alternatively, tbr a given (higher) rent P°(T), it is simple to solve for the equi librium exercise price, E, on the embcdded call option.
8.
Percentage
leases and credit risk
In the U.S., the percentage lease is the dominant method of leasing retail space in shopping malls. This is clearly an important sector of the leasing lnarket, with almost 38,000 shopping centers in the U.S. accounting for over $700 billion in retail sales in 1991 (Shopping Center Directions, 1992). The rents paid by different classes of mall tenants vary substantially. In 1992, the median rent per square loot paid by department stores in super regional shopping malls was S1.95 (Dollars and Cents of Shopping Centers, 1993). For home furnishing stores thc median rent was $25, and lbr jewelry stores the median rent was $42. In addi tion, the average rent per square foot for stores that were members of national chains was only around half as high as that lbr independent stores. Undcr a percentage leasc, the shopping center owncr collects a fixed base rent plus a pcrcentagc of the store's sales, provided the store's sales exceed a given thresh old. In a defaultli"ee context, such contracts have been analyzed by Bcnjanlin, Boyle, and Sinnans (1990) and Grenadier (1995). Because percentage leases are most coinmon on the smaller mall shops, thc impact of credit risk may be considerable. Percentage leases are a special case of a more general form of leasing structure in which rent is tied to some measure of the intensity of an asset's use. Ex amples inchide car leasc rates linked to mileage, copy machine rents linked to the numbcr of copies, and computer leases linked to CPU cycles. Smith and Wakelnan (1985) provide a discussion of the rationale underlying such leasing arrangements.
of
The
model
can
be applied
to valuc
the percentage
lease
under
conditions
potential default. The contract specifies a base rent, Rs~, which must be paid regardless of sales performance. In addition, should sales rise above a threshold ~, a percentage p of the level of sales above the threshold is paid to the landlord. Assume that the store's sales are proportional to the asset value of the space, i<. V [S(I)]. Thus, the lease payment (flow) made at time 1, Rl'(t), contingent on
S.R. Grenadier/ Journal of FinancialEconomics 42 (1996) 333 364
no default having occurred, is
RP(t)=R B +max
100"
=
Re +
100 "max [V[S(t)] 
~c
357
The rental payment on a percentage lease (contingent on no default having occurred) is equal to the sum of a fixed payment, Re, plus the_payoff on p~c/100 purchase options on the underlying asset, with exercise price S/tc and expiration date t. The value of such an option was derived in Section 6: at time zero the value of such a purchase option is H(S,X,O;t,S/t¢). For the case in which S and X follow correlated geometric Brownian motions, a closedform solution for H (S,X, 0; t,E) is presented in the Appendix, and its properties were analyzed in Section 7. The value of the percentage lease, LP(S,X,t; T, p, RB,S), is therefore equal to the value of a standard risky lease with rental RB, plus the timeintegral (sum) of purchase options. Using the value of a standard lease (F) derived in Section 2 and the value of a purchase option (H) derived in Section 7, the value of the payment flow from a Tyear percentage lease, as of time t  0, is
LP(S'X'O;T'p'R~'S) F(S'X'O;RS'T)+ 100 H 
S,X,O;t, 
dr. 

(27) 

In equilibrium, the value of selling the use of the asset 
for 
T years under a 
percentage lease must equal the value of selling the use of the asset under a standard Tyear riskless lease, Y(S,T). Therefore, equilibrium combinations of (p,R~,S) are solutions to the following equality:
Y(S, T)  LP(&X,O; T, p, Rg, S).
9. Conclusion
(28)
1 derive a model that provides a unified approach to the equilibrium valuation of leases subject to default risk. Using an optionpricing approach, the model allows for a stochastic service flow from the leased asset, as well as for the stochastic occurrence and consequences of default. The model is flexible enough to permit the determination of equilibrium rental rates under a wide variety of realistic leasing structures. Such structures include security deposits, upfront prepayments, lease credit insurance contracts, embedded lease purchase options, and percentage leases.
358 S. R. Grenadier~Journal o]" Financial Economics 42 (1996)
333~64
Several extensions of the model would prove interesting. First, a richer model would include a treatment of the asset supply sector of the industry. That is, rather than taking the equilibrium service flow (and asset value) as exogenous, a more realistic treatment would include a consideration of the equilibrium construction response of suppliers. Second, the model could be empirically tested on actual lease contracts. The availability of large and reliable samples of individual lease contracts is currently quite difficult to obtain. The model suggests that equilibrium lease rates will be sensitive to the stochastic processes underlying both the leased asset and the lessee's firm value. In addition, the terms of the contract (e.g., maturity, embedded options, prepayment, and security deposit provisions) must be carefully taken into account in the empirical specification.
Appendix
A. 1. Explicit
solutions jor
lease contracts
In this section of the Appendix, I present explicit solutions for various leas ing contracts presented in the model for the case in which S and X evolve as correlated geometric Brownian motions, i.e.,
dS
dX


~,,,Sdt +
a, Sdz,,,
~.,Xdt + axXdz,,
^{(}^{2}^{9}^{)}
and where p is the instantaneous correlation coefficient between the Wiener pro
cesses dz,
will be lognormal
random variables.
and dz.,
Under this specification, S(t)
and X(t)
The riskh, ss h'ase
Eq. (2)
defines the value of a
Tyear riskless lease by the function
Y(S, T).
Using the properties of lognormal variables, the expected value of the integral can be written as
Y(S, T)
F
S

3~
[1
e
(r
x,
)r]
.
(30)
Eq. (3) cxpresses the equilibrium riskless rent R(T) as the payment flow whose annuity value equals the value of the riskless lease, Y(S, T). Using the solution (30), the riskless rent can be written as
R(r)
1
e ('~'ir)

] ~V~
rS
I ,.~,
(3
1
)
S.R.
Grenadier/Journal
o.1 Financial Economics
42
(1996)
The value of a risk),, Tyear lease
333
364
359
In Eq. (12), a formula for the value of a Tyear lease is denoted by the function F(S,X,t;P, T). The explicit solution is
F(S,X,t;P, T)
where
~(P'~)
=
q~2(X, z) =
qo3(X, z)
P[I
7
G(X,T,y)=N
Vbl(P,r) 
e'~]
P
cb2(X,r). 
F
+ q)3(X,z)(1
G(X, z, a2 ) 
er~G(X, ~, al ),
co)
S

F
~
G(X, r, aa) 
[In(K/X)
y.z
e0
~')TG(X, r, a3) ,
'" ~
[In(K//X)+ y.r
(32)
• 
L 
a~x/ff 
+ 
, N 
k 
' 

a2 
al 

C I 
0.~ 

O 4 
 
a 
3 

C2 
0"2 

I 
2 

al 
= 
~.v 
 
~0x 
, 

a2 
= 
{a~ 
+ 
2r0{ , 
a3 
= 
Y.v 4 pCix0s  
2 I ~0x , 

a4 
= 
a? + 
2(r 
 ~,)a~, 
r=T
t,
and where N() denotes the cumulative standard normal distribution function.
The equilibrium security deposit
The solution to differential equation (16) subject to boundary conditions (17),
W(S,X,t;P r) T,M),
evaluated at time t =
0, can be written
W(S,X, O; P z~, T.M) = F(S,X, O; pD, T) + m
. Q(X, T)

as
B(S,X; T,M, O,¢o) ,
(33)
360 
S.R. Grenadier~Journal of Financial Economics 42 (1996) 333 364 
where 
B(S,X; T,)h,y2,y3)
_{[}
b(S,X,T, yl,Y2, Y3, v)dv,
b(X,X~ L J,'~, y2, y3, v) = er~ O(X, v) [b, (S,X, T, >,1,y2, Y3, v)
b2(S,X, 7",Yl, Y2, y3, v)=
fI(T,
yl,Y2,
v)
=
er"
)'1
f2(T,)'3,t'));3[le
g(X, ~) 
al
~
gv
ln(~'/K)
2
1
~ O'r ,
,,=(S,X,t:):ln(
F
exp
S
3~s
b2(&X, T, )h, Y2, Y3, v)] ,
)1]
K ~:exp [pz(S,X, v) + ½a~(t:)2]
"./2 (T,)'3, g') N
In
~.(s,x,
~,) ~(v)2)
q )'2
r
{r
~,)(T ~,)] ,
[(In(X/K)_+
[
2a.~ t;
Hi
u)2
e
'
~(T,
rr
1
)_)~ln(X)+
[e,,a://2
''
ya,~OK7 /
J
2@,
4,/'2)],,,
& R. GremtdiertJournal o!' Fimmcial Economics 42 (1990)
a:(~:)
},, (<
F
;. = pa.~/c*~.
The value ql'a
h,asu credit insurance contract
333 364
361
The solution to partial differential equation (20) subject to boundary conditions
(21 )
is
T(S,X, 0; T,?)  B(S,X; f,0,?, 1
~o),
(34)
where the function B(S,X; T,y~,y2, y3) is defined in Eq. (33) defined earlier in the Appendix.
The option to purchase the underlvin.q asset on a risky lease
In Section 7, the solution to partial differential equation (23), subject to bound ary conditions (24), serves to define the option to purchase the underlying asset. The explicit solution may be written as
[
H(&X,O; T,E) =X~,,"V/a~T.ex p It:(T) + a~(T),,,'2
,
x [~(2a~,O,a~(T),T,E)
(2ra~ +/,2)T]
20?
]
,/J ().¢~, 21n(X/'K) a:(T),T,E) ]
where
_E/~Texp[
(2r¢~+~t~2)T]
2o~
J
[
• O(O,O,O,T,E)~
(2In(X/K)
0,
rr~v~
I//(YI'Y2 Y3 T'E)=a"'/TexP [½( (# arYl)X/f
Y2
xN2
[h (Yl, 3'2,Y3,
T,E),
In(X/K)
O.~N/~
(# 
y,)
Ox
+ y2, ~'(T)]
2
I
i )'2
362 S. R. Grem,dier/ Journal {~f Financial Economics 42 ( 1996) 333 364
h(yl 
v2,Ys, T,E) = (t&(T) 

' 

+)'3 

x~(1 

;,~x,/v 

^{v}^{(}^{T}^{)} 
^{} 

,/~(T) 2 = pa.~./ax, 
+ ~:~T 
' 

la 
a2/2 
~,~, 
^{I}^{n}^{(}^{E}^{/}^{/}^{X} ^{~}^{}^{)}
~(>7
/~
~
V%(T)
"
v(T)2) ,
p:(T)
a.(T)
=
In
(
~
S
~/(a 2 
)

21n(X) +
~o2a2)T,
[~,,, 
a.2/2

o,
)~(~x 
a~/2)]T
,
and N2(xl,x2, v) denotes the cumulative standard bivariate normal distribution function. That is, let X1 and X2 be two standard normal random variables with correlation v. Then I~2(XI,X2,Y) is the probability that Xi ~<xl and X2 ~<x2.
A.2.
Valuation of 'defaultcontingent'
put
option and zerocoupon
bond
represents the value of a put option on the asset
with exercise price E and expiration date T, contingent on no default. The value of the option will satisfy the following equilibrium partial differential equation:
In Section 7, J(S,X,t; T,E)
0 la2(S,t)S2Jss +p(S,X,t)a,.(S,t)a,(X,t)SXJsx
+ 7a~(X,t)X"JA;¥
1
O
";'
+z(~.(S,t)SJs + ~x(X,t)XJx +.]1  
rJ, 
(36) 

subject to the boundary conditions 

J(S,X. 7"; T,E) = 
max [E  
V(S),0] , 

J(XK, 
t; T,E) 
O. 
(37) 
The first boundary condition is the put option payoff at maturity. The second boundary condition reflects the fact that the value of the option falls to zero should the lessee default.
S.R. Grenadier / Jourmd q/' Financial Economics 42 (1996) 
333 364 
363 

The 
value 
of a zerocoupon 
bond 
which 
pays 
$1 
at time 
T 
only 
if there 
is 
no 
default is denoted as N(X, t; T). The value of this bond will satisfy the following
equilibrium
partial
differential
equation:
0
2:
1
~rTxI,A,
tx,:2r, r
)A
~'~a" + ~.v(X,t)XNx
+
Nt
 rN,
(38)
subject
to the
boundary
conditions
N(X, T; T)  
I, 

(39) 

N(K,t; T) 
= 
O. 

The first boundary 
condition 
is the bond payoff at maturity. The 
second 
boundary 

condition reflects the fact that the value of the bond default. falls to zero 
should the lessee 
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