ELSEVIER

Journal of Financial Economics 42 (1996)333-364

J O U R N A L O F
Financial
ECONOMICS
Leasing and credit risk
Steven R. Grenadier
Graduate School ()/' Business, Stanjord University, Stan/brd, CA 94305-5015, 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 default-free 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 real-world leasing structures, including security deposits,
required up-front prepayments, embedded lease options, leases indexed to use, and lease
credit insurance contracts.
Key words: Leasing; Options; Credit risk
J EL classification: GI2; G13; G32
1. I nt r oduc t i on
Leasi ng is olden percei ved as a substitute for debt for firms that are ' t oo ri sky or
are unable to access convent i onal debt mar ket s' (Lease, McConnel l , and Schall-
hei m, 1990). In the U.S., al most one-t hi rd o f total busi ness i nvest ment is leased.
In 1993, equi pment leasing alone was val ued at over $125 million, with smaller
firms represent i ng a di sproport i onat el y large share o f this activity. Despite em-
pirical evi dence poi nt i ng to a st rong similarity bet ween lease cont ract s and j unk
bonds, the theoretical model i ng o f equi l i bri um lease det ermi nat i on has been virtu-
ally confi ned to defaul t -free leases (a notable except i on is Lewi s and Schallheim,
1992, who t ake into account defaul t risk in a si ngl e-peri od model o f the equi-
librium rental rate). Gi ven the large vol ume o f research devot ed to the st udy o f
corporat e bond credit risk, it is puzzl i ng that the risk of l easi ng has been l argel y
ignored. A model of lease default risk is i mport ant not onl y for the det ermi nat i on
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.
0304-405X/96/$15.00 1996 Elsevier Science S.A. All rights reserved
P I I S O3 0 4 - 4 0 5 X ( 9 6 ) 0 0 8 8 2 - 3
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 real-world leasing arrangements such as security deposits, required up-front
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 approxi mat el y equivalent debt-financing arrange-
ments. Crawford, Harper, and McConnell ( 1981) r epor t 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 high-yield (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 pert brmance 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 approxi mat el y 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 1973-1982 period. Blume
and Kei m (1991) find that for lower-grade bonds issued during 1977 1978 the
promised yield exceeds the realized return by 2.61%. Thus, there is evidence that
leases and high-yield 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 mechani sm 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. Gr enadi er / Jour md o! Financial Economi cs 42 ( 1996) 333 364 335
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 option-pricing
approach to equilibrium lease valuation. This approach has been followed by sev-
eral authors. Smith (1979) provides an option-like characterization for a lease: a
T-year 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 option-pricing framework to provide
a thorough analysis of a wide variety of lease options and insurance contracts.
Grenadier (1995) combines an option-pricing 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 real-world leasing, it also neglects some very important leasing
considerations. In particular, there is a vast literature on the importance of taxes
in the lease-versus-buy 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 payment s 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 l essee' s
stochastic cash flow (or asset value) falls to a lower default barrier. Upon default,
the lessor receives only a fraction of the l ease' 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 comput er 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. Grenadi er/ Journal ()]' Financial Economi cs 42 (1996) 3 3 3 ~ 6 4
that some of the future rent payments be made up-front. How many months'
prepaid rent can you demand in equilibrium?
3. As an issuer of asset-backed 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), 'third-party 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 third-party 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 lease-backed securities. Similar to other asset-backed securities,
lease-backed 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 Economi cs 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 l essee' 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
one-period 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 probl ems 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 payment s 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 option-pricing analysis.
Traditionally, in the option-pricing 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 Economi cs 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 risk-free
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:
d S = ~. , . ( 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 T-year lease to a riskless lessee. This
represents the sale of the use of the asset for T years in return for a sure payment
flow of R ( T ) . The value of the use of the asset for T years, Y( S, T) , can be
expressed as follows:
( / / )
Y( S, T ) = E e - r r S ( t ) d t . (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 ) y ( s , T ) (3)
R ( T ) 1 e ,-r "
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 ) , is then the perpetuity value of S(t):
V ( S ) = lim Y ( & T ) . (4)
2An extension of the present model to accomodat e stochastic interest rates could be accompl i shed in
a manner si mi l ar to Brcnnan and Schwartz (1980) and Kiln, Ramaswamy, and Sundaresan (1993).
Usi ng numerical solution t echni ques, t hey find that t he yield spreads between corporate and Treasury
bonds are quite i nsensi t i ve to interest rate uncertainty.
S. R, Grenadi er/ Journal o ! Financial Economi cs 42 ( 1996) 3 3 3 ~ 6 4 339
Now consi der a T- year l ease when t he l essee is subj ect to t he r i sk o f defaul t .
Whi l e t he l essee ma y pay t he pr omi s e d r ent al rat e P( T) over t he ent i re l ease
per i od, t here is al so t he pos s i bi l i t y t hat t he pr omi s e d payment is not r eal i zed.
Lease def aul t is cont r act ual l y defi ned, and ma y consi st o f l at e payment s , f ai l ur e
to mai nt ai n t he asset , or f ai l ur e to fulfill t he covenant s o f ot her fi nanci al con-
t ract s. The causes o f def aul t are al so var i ed. Busi ness fai l ure, l i qui di t y cr i ses, and
di ssat i sf act i on wi t h t he per f or mance o f t he l eased asset ma y under l i e t he f ai l ur e
to uphol d t he t er ms o f t he lease.
Lease def aul t ma y be br oken down i nt o t wo part s: t he occur r ence o f def aul t
and t he cons equences o f defaul t . To model t he occur r ence of defaul t , I f ol l ow
Bl ack and Cox ( 1976) , Lel and ( 1994) , and Longst af f and Schwar t z ( 1995) by
as s umi ng t hat def aul t occur s when a fi nanci al st at e var i abl e o f t he l essee, such
as cash flow or asset val ue, fal l s to a l ower t hr eshol d K. Thi s defi ni t i on of
def aul t is consi st ent wi t h bot h t he case in whi ch t he l essee is i nsol vent becaus e
it does not gener at e suffi ci ent cash flow to meet cur r ent obl i gat i ons, as wel l as t he
case in whi ch t he l e s s e e ' s asset s vi ol at e mi ni mum net wor t h or wor ki ng- capi t al
r equi r ement s. Such a def aul t condi t i on can t hus account for bot h f l ow- bas ed and
s t ock- bas ed i nsol vency, as di scussed in Wr uck ( 1990) and Ki m, Ra ma s wa my,
and Sundar esan ( 1993) . Ot her si mi l ar appr oaches to mode l i ng t he occur r ence o f
def aul t are di s pl ayed in Mer t on ( 1974) , Duffle and Si ngl et on ( 1995) , and Jar r ow
and Tumbul l ( 1995) .
Let X( t ) denot e a st at e var i abl e of t he l essee, such as cash fl ow or asset val ue.
I f X( t ) fal l s to t he boundar y K, t he l essee defaul t s. Thi s coul d r epr esent late or
mi s s ed payment s , or out r i ght abr ogat i on o f t he l ease. Thus, def aul t occur s on a
T- year l ease i f t he first passage t i me o f X( t ) to t he boundar y K is l ess t han
T. Mat hemat i cal l y, def aul t occur s at t i me t* wher e t* = i n f [ t < T: X( t ) <~K] ,
wher e t* = .~c i f no such t exi st s.
As s ume t hat X( t ) f ol l ows a di ffusi on pr ocess t hat is cor r el at ed wi t h t he val ue
of the l eased asset as f ol l ows:
dX = ~,,(X, t ) Xdt + ~,.(X, t ) Xdzs , ( 5)
wher e :zx(X, t ) is t he i nst ant aneous condi t i onal expect ed per cent age change in X
per uni t t i me, a.,-(X, t ) is t he i nst ant aneous condi t i onal st andar d devi at i on per uni t
t i me, and dzx is t he i ncr ement o f a st andar d Wi e ne r pr ocess. Let p(S, X, t) denot e
t he i nst ant aneous cor r el at i on coef f i ci ent bet ween t he Wi ener pr ocesses dz~. and
dz~. I f p is posi t i ve, t hen def aul t is most l i kel y to occur when t he val ue o f t he
asset is t he l owest , and t he cons equences o f def aul t are t he most severe. I f p
is negat i ve, def aul t is most l i kel y to occur when t he asset val ue is t he hi ghest ,
and t he cons equences o f def aul t are t he l owest (i . e. , t he asset can be r e- l eased at
hi gh r at es) .
Thi s defi ni t i on o f t he occur r ence of def aul t is consi st ent wi t h Hul l and Whi t e ' s
( 1995) mor e gener al model i ng o f defaul t . Hul l and Whi t e as s ume t hat def aul t
occur s at t he first t i me, t, when G(4), t ) - 0 for s ome f unct i on G, wher e q5 is
340 S. R. Grenadi er~Journal o1' Financial Economi cs 42 ( 1996) 333 364
a vect or o f state vari abl es det ermi ni ng the occurrence o f default. By al l owi ng
4) = X//K and G l n( ~) , the present model is a special case o f their mor e
general model .
Now that the event o f default is defined, 1 model the consequences o f default.
Once again, the consequences and remedi es depend on the terms o f the lease.
The l essor may sell the asset, demand payment o f all future lease payment s, or
re-lease the asset. The underl yi ng asset may be damaged due t o negl ect , and the
likelihood o f r ecover i ng damages may be low. There also are likely to be losses
due to delay, legal costs, and br oker age and market i ng costs. I f default occurs at
time t*, and i f the asset coul d be fully r ecover ed and i mmedi at el y re-leased, the
remai ni ng val ue o f the lease woul d be Y[S(t*), T - t*]. To model the costs o f
default, I assume that the l essor is onl y able to recei ve a fraction, 1 {,~, o f this
remai ni ng lease value, where ~ q [0, 1].
Nielsen, Safi-Requejo, and Sant a-Cl ara (1993), Lel and (1994), and Longst af f
and Schwart z ( 1995) al so assume a proport i onal loss in their model s o f bond
default. The payoffs to cl ai mant s in the event of defaul t depend on a host o f
exogenous factors, most i mport ant l y the bargai ni ng power of interested parties.
One may consi der c~) as the out come to a bargai ni ng process. Al t hough I treat ~o
as a constant, this f r amewor k coul d easily be general i zed to allow for stochastic
val ues o f a). Because co enters the payoff" funct i on linearly, onl y its expect at i on
matters. Thus, one can si mpl y interpret ~o as the expect ed val ue o f the loss due
to default.
To derive the equi l i bri um rent on a ri sky T- year lease, P( T) , I once again use
the underl yi ng concept of equilibrium: any t wo met hods o f selling the service
flow o f the asset for T years must have the same value. Consi der the f ol l owi ng
t wo alternative met hods o f selling the service fl ow for T years.
Alternative 1: Lease the asset for T years to a lessee fi'ee o f credit risk. The
value o f this alternative is Y(S, T).
Alternative 2: Lease the asset under a T- year lease to a ri sky lessee, at the
rental rate P( T) . I f the event o f default occurs at t i me t < T, lease the asset out
for the remai nder o f the t erm ( T - t ) to a riskless lessee. Due to the costs
o f default, however, the lessee is onl y able to r ecover a fract i on 1 - , ) o f
Y [ s ( t ) , r - t ] .
1 now derive the value o f Al t ernat i ve 2. In equilibrium, P( T) is set at the out set
o f the lease such the val ues o f Al t ernat i ves 1 and 2 are equal. Let F( S, X, t; P, T)
denot e the val ue o f Al t ernat i ve 2, where t is the current time and S and X are
the current val ues o f S( t ) and X( t ) , respectively. Let P be a gi ven rent rate (to
be det ermi ned in equi l i bri um).
Consi der the i nst ant aneous return on F over a regi on in whi ch the lessee
has not yet defaulted: X( v) > K, Vv~<t. By I t 6' s l emma, the i nst ant aneous change
S.R. Grenadier/JourmH of Financial Economics 42 (1996) 3 3 3 3 6 4 341
in F i s
dF = c~(S, t )S Fss +p(S,X,t)c~.(S,t)c(~(X,t)SXFsx
1 2 ]
+ 5c;~(X,t)X2Fxx + ~( S, t ) SFs + ex(X, t )XFx + Ft dt
+ ~s(S, t)SFsdz, + ax(X, t ) XFxdzx. ( 6)
I n a ddi t i on t o t he c a pi t a l ga i n r e c e i v e d on t hi s l eas e, t he l e s s or r e c e i v e s a c a s h
i nf l ow due t o t he r e nt s o f P d t . Th e r e f o r e , t he t ot al e x p e c t e d r e t ur n on F pe r uni t
t i me , /~f, is de f i ne d as
I ~Fdt - E [dF +FPdt ] . ( 7 )
Set t i ng t he e x p e c t e d r et ur n e qua l t o t he e q u i l i b r i u m r et ur n r and s i mp l i f y i n g
yi e l ds t he f o l l o wi n g e qui l i br i um par t i al di f f er ent i al equat i on:
0 1 2 1 2
a, (S, t)SZFss + p(S,X, t)a, (S, t)ax(X, t)SXFsx + ~ ax(X, t)X2F~c
+ ~ , ( S , t)SFs + ex(X, t )XFy + F~ + P - r F. ( 8 )
Thi s par t i al di f f er ent i al e qua t i on i s s o l v e d s ubj e c t t o b o u n d a r y c ondi t i ons de -
f i ned b y Al t e r n a t i v e 2. At t he mo me n t de f a ul t oc c ur s , wh e n X( t ) ~ K, t he l e s s or
obt a i ns a f r a c t i on o f t he va l ue o f t he r e ma i n i n g l eas e, (1 - co) - Y[S(t), T - t].
Thi s de f a ul t b o u n d a r y c ondi t i on c a n b e wr i t t e n as
F ( S , K, t ; P , T ) - - (1 - co) - Y[S(t), T t]. ( 9)
Al t e r na t i ve l y, i f no de f a ul t oc c ur s o v e r t he l i f e o f t he l eas e, t he t e r mi na l c on-
di t i on e n s u r e s t hat t he va l ue o f t he r e ma i n i n g r ent al p a y me n t s e qua l s z e r o at
ma t ur i t y:
F( S, X, T;P, T) ~ O. ( 10)
No w, b y s p e c i f y i n g t he p a r a me t e r s o f t he s t ochas t i c p r o c e s s e s f o r S( t ) a nd
X( t ) , [es(S,t),c~x(X,t),p(S,X,t)], we c a n s ol ve par t i al di f f er ent i al e qua t i on ( 8)
s ubj e c t t o b o u n d a r y c ondi t i ons ( 9 ) a nd ( 10) . I n gener al , c l o s e d - f o r m s ol ut i ons
wi l l not be a va i l a bl e . Ho we v e r , s uch e qua t i ons c a n be s o l v e d u s i n g nume r i c a l
t e c hni que s .
Fi nal l y, t o de r i ve t he e q u i l i b r i u m r i s k y r e nt on a T- y e a r l ease, I us e t he equi l i b-
r i um c ondi t i on t hat t he v a l u e s o f Al t e r na t i ve s 1 a nd 2 mu s t b e equal . Th e r e f o r e ,
t he e qui l i br i um r ent on a T- y e a r l e a s e s ubj e c t t o de f a ul t r i sk, P( T) , is set at t i me
z e r o s uch t ha t t he f o l l o wi n g e qua l i t y is sat i sfi ed:
F( S, X, O; P( T) , T) = Y(S, T) . (1 1)
I wi l l n o w a s s u me t hat S( t ) and X( t ) f o l l o w c or r e l a t e d g e o me t r i c Br o wn i a n
mo t i o n s ( j oi nt l y l o g - n o r ma l ) . Thus ~s(S,t), ccx(X,t), a nd p( S, X, t ) ar e e qua l t o
342 S.R. Grenadier/Journal o/ Financial Economics 42 (1996) 333 364
the constants ,~,., ~ , and p, respectively. Such an assumption is very standard in
the financial and real-options literature. This will permit a closed-form solution
to be obtained.
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) P
= . - +cb3( y, r ) . ( 1 (o) S
r r fZs
(12)
where z - T t, and the functions q51(P,r), q O 2 ( X , 2 " ) , and 4~3(X,r) are presented
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 i f
the lease is risk-free. The second term, q~2(X,r)- (P/r), is the value of the
potential loss of all contracted rentals i f 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 log-normal 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
r . S - e (r ~, )r ( , 0) ]
p ( T ) = ( ~ ) [ 1 - @3 ( X, T ) . ( I
]- 7 7- 7Y 7 ~-2(~-~k ~ ] '
(13)
3 . A n a l y s i s o f t h e l e a s e c r e d i t r i s k s p r e a d
Lessors of assets will adjust the rents charged to a risky lessee to ensure
indifference relative to a lessee with no credit risk. The credit risk spread, D( T) ,
is defined as P ( T ) - R(T). In this section, I analyze the factors that influence
the size of the cushion demanded on risky leases.
In essence, this analysis is analogous to the study of the risk structure of
interest rates. In Merton (1974), the comparat i ve 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 l essee' 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 closed-form
solution for the equilibrium credit spread can be derived. Subtracting Eq. (13)
from the solution to Eq. (3) provided in the Appendix, the credit risk spread can
be written as
D(T) = ~ 1 - e - ' r - qO2(X, T) i - ~ - e r ~ - J "
(14)
The impact of various paramet er changes on the credit risk spread are illustrated
in Figs. l a through lf. 3
Fig. l a 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 upward-sloping. That is, for longer-term 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, short-term 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, longer-term 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 premi um
than risky apartment tenants. In addition, the concavity of the term structure of
lease credit spreads suggests that for long-term leases, the premi um required to
compensate for risk moderates.
Fig. l b 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, i f 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. I f the lessee defaults on the lease, it is also likely to
3While t he resul t s here are derived under a base case set of initial paramet er values, t hey hold under
a wide variety of realistic parai net er values. However , it is i mport ant to note that for significantly
negative val ues of p, and relatively sale leases (hi gh X/K), the credit spread can actually become
negative. That is, one mi ght theoretically charge a l ower rent for a lessee subject to default than for
a lessee with no credit risk. The key to this surpri si ng result is in t he negat i ve correlation. Default
is most likely to occur when the asset can be re-leased at unexpect edl y hi gh values, pot ent i al l y even
great enough to compensat e for t he fraction of t he service flow, {o, lost in default. The condi t i ons
under whi ch this result obt ai ns are unlikely to be observed in actual leasing markets.
344 S. R. Grenadier 1 Journal q/ Fi nanci al Economi cs 42 ( 1996) 333 364
Spread
[ F i g . l a I
1o
1"
Spread
6
2
0 I I I I I
0.05 095
Sp r e a d 40
3O
20
io
o
Spread
2
05
I Fig. l c I
Spread 2
I
1.5
X/K
i 5
1
05
(I
Spread
10
J
/ ~ p = 0
~ = - . 2
I I I I 0
05
(5 s
I I I I
o I
P
o5
Fi g. I. An a l y s i s o f t he l ease c r e di t s pr ead.
A l ease cr edi t s pr e a d is def i ned as t he di f f er ence be t we e n t he e qui l i br i um r ent p a y me n t on a
7' - year l ease s ubj ect t o c r e di t ri sk a nd t hat c h a r g e d on a r i skl ess T- y e a r l ease. The l ease c r e di t
s pr e a d is der i ved in Eq. ( 14) . The si x g r a p h s in t he l i gur c s h o w t he ef f ect o f c h a u g e s in t he unde r -
l yi ng p a r a me t e r va l ue s on t he e qui l i br i um c r e di t s pr ead. Fi g. l a s h o ws t he effect o f i nc r e a s i ng T,
t he t e r m o f t he l ease. Fi g. l b s hows t he ef f ect o f i n c r e a s i n g ~o, t he pr opor t i on o f t he l ease va l ue
l ost in t he event o f def aul t . Fi g. l c s h o ws t he effect o f i nc r e a s i ng t he r at i o o f t he l e s s e e ' s as s et
val ue t o t he de f a ul t t r i gge r , X/'K: tile c l os e r t he r at i o is t o one, t he gr e a t e r t he l i ke l i hood o f def aul t .
Fi g. l d s hows t he ef f ect o f t he c or r e l a t i on, p, b e t we e n t he l eas ed as s et va l ue a nd t he l e s s e e ' s as s et
val ue. Fi g. l e s h o ws t he elt;ect o f t he vol a t i l i t y o f t he l eased asset , o-~, f or di f f er ent va l ue s o f t he
c or r e l a t i on coef f i ci ent . Fi g. I f s h o ws t he ef f ect o f t he vol a t i l i t y o f t he l e s s e e ' s as s et val ue, cry. The
de f a ul t p a r a me t e r va l ue s ar e : q O, ~v - 0. 02, o-~ - 0. 15, o2, 0. 15, p - 0. 5, r 0. 05, u) 0. 2,
T - 5, S 10, a nd 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. l c plots the impact of the ratio of the l essee' 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 risk-free lease. In
addition, the spread is convex in the ratio ~,"K. This suggests that the spread in-
creases rapidly as the l essee' 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 premi um charged to ' j unk' tenants.
Fig. l d plots the impact of the correlation (p) between the l essee' 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 fi rm' s assets fall enough in value to trigger
default, it is more likely that the underlying asset (and the l ease' 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 movement s in the lessee' s cash
flows are correlated with movement s 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 comparabl y
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. I f p is positive,
the spread is increasing in r~,.. I f p is negative, the spread is decreasing in rT,..
I f /) is zero, the spread is constant in r;,.. The intuition is as follows. I f p is
positive, the event of del;ault is likely to occur when the underlying asset value
is depressed. I f 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
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.
Fig. I f plots the impact of the volatility of the lessee's financial 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.
4. The equilibrium securi ty deposi t
Many real-world 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 T-year 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. I f 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 i f 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, i f 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 *) , T - t * ] + 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 zero-coupon 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 ) S X Ws . x + ~ r ; ( X , t ) X Z W x x
+: ~, . ( S, t ) SWs + ~, , ( X, t ) XWx + )~t + pD _ r W , (16)
subject to the boundary conditions:
W ( S , X , T ; P ~ ) , T , M ) O,
Y [ S ( O , r - t ] + M e "
- max { M e ' - , o . Y I S ( t ) , T - t ] , 0 } , (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, P n ( 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, p D ( T , M ) must be the
solution to the following equality:
F ( S , X , O ; P ( T ) , T ) W( S , X , O ; P D ( T , M ) , T , M ) . (18)
348 X R. Grenadier~Journal oj Financial Economics 42 (1996) 333 364
Equi l i br i um Rent
12
11
10
I I I I
0 2 4 6 8
Deposi t
Fig. 2. The effect of security deposit on equilibrium rent.
This graph shows thc equilibriuln rent on a risky five-year 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 t he Ap p e n d i x , a s ol ut i on f or W( S, X, o; pD, T, M) is de r i ve d f or t he cas e in
wh i c h S and X e v o l v e as cor r el at ed g e o me t r i c Br o wn i a n mot i ons . Co mb i n e d
wi t h t he s ol ut i on f or F( S, X, t ; P, T) , t he e q u i l i b r i u m s ol ut i on f or PZ) ( T, M) can
be der i ved.
Fi g. 2 pl ot s t he e q u i l i b r i u m l ease r at e as a f unct i on o f t he s ecur i t y depos i t . On
a f i ve - ye a r l ease, t he r ent f al l s f r om $11. 50 wi t h no s ecur i t y de pos i t t o $10. 60
wi t h a $5 s ecur i t y deposi t . In e qui l i br i um, t her e wi l l be an i nf i ni t e n u mb e r o f
c o mb i n a t i o n s o f r ent and s ecur i t y de pos i t t hat l eave t he par t i es i ndi f f er ent . Of
cour s e, t he pr eci s e c o mb i n a t i o n c hos e n s houl d be ef f i ci ent in t hat it mi n i mi z e s
t he cost s o f f act or s such as a dve r s e s el ect i on, mor al hazar d, cr edi t ver i f i cat i on,
and moni t or i ng.
5. The equilibrium prepayment clause in risky leases
An o t h e r f or m o f pr ot e c t i on agai ns t cr edi t ri sk is a p r e p a y me n t cl aus e. A ve r y
c o mmo n cl aus e in l eas es r equi r es t he l es s ee t o ma k e one or mo r e p a y me n t s in
a dva nc e . As not ed by Sc ha l l he i m ( 1994) , a hnos t al l l eas es d e ma n d s o me f or m
o f pr e pa yme nt , but t he a mo u n t wi l l va r y a c c or di ng t o t he de gr e e o f cr edi t risk.
Pr e pa yme nt s in t he r a nge o f one to si x mo n t h s in a dva nc e ar e qui t e c o mmo n .
S.R. Grenadier I Journal of Financial Economics 42 (1996) 333-364 349
According to the contract, i f the lessee pays n mont hs' rent in advance, the final
n months of the lease are rent-free.
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 T-year 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 up-front 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 up-front security deposit of 6 years rent, 6 R(T).
I f the lessee makes all payments up to time T - 6, then the lessee retains use
of the asset for the remainder of the t erm and makes no rent payments. I f the
lessee defaults at any time t < T - 6, then the lessor re-leases 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 right-hand side
of boundary condition (9) will be (1 - o)). Y[S(t), T + T - t]. Since the second
alternative is equivalent to an up-front payment of 6. R( T) plus a risky lease
with a term of T years with lease payment s 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 closed-form 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, a 4 ) - e-(r-~-')(T+T)G(X,z, a3).
Fig. 3 plots the effect of increasing credit risk on the equilibrium prepayment
period. In this figure, I allow for the lessee to become decreasingly risky by
350 S. R. Grenadier~Journal o1" Financial Economics 42 (1996) 333364
Equilibrium
Pr e p a y me n t Pe r i o d
3 yrs.
2 yrs.
1 yrs.
0 yrs.
"~.......
, ' %
' , " - .
% " " - . .
": "'. . . . . . o- x = .25
. . . .
: "..~ =.15 .... """ ....
'..c~ x = .05 " ' - .
' . . . . . . . I . I . . . . . . . . . . . . . . . . . I . . . . . . . . . . . . . . . . . 1
1.25 1.5 1.75 2
X/K
Fig. 3. The effect of credit ri sk on t he equi l i bri um pr epayment period.
Thi s gr aph s hows t he equi l i bri um peri od of rent whi ch mus t be prepai d on a risky fi ve-year lease,
as t he l es s ee' s initial credit posi t i on varies. On this lease, a ri skl ess rent is charged, pl us t he l essor
demands a peri od of prepai d rent. As t he ratio of the l es s ee' s asset val ue to t he default trigger,
X/ K, rises, t he l es s ee' s l i kel i hood of defaul t falls: i f X/ K- l , t he l essee will default i mmedi at el y; i f
X/ K --~ oc, t he lease is riskless. For l essees on t he bri nk of default, a significant por t i on of t he lease
mus t be prepaid. For l essees far from t he default boundar y, al most no pr epayment is required. Thi s
effect is demonst r at ed for three different levels of t he l es s ee' s volatility, ~r~. The great er t he uncert ai nt y
of t he l essee' s ability to make t he fut ure lease payment s, t he great er t he requi red pr epayment period.
The default par amet er val ues are ~s. - 0, ~x - 0.02, ~. - 0.15, p - 0.5, r 0.05, co 0.2, T = 5,
and S 10.
r a i s i ng t he r at i o X / K f r o m j u s t a b o v e uni t y ( at wh i c h de f a ul t oc c ur s i mme d i -
a t e l y ) t o l e ve l s at wh i c h de f a ul t b e c o me s vi r t ua l l y i mpos s i bl e . For l e a s e s on t he
t hr e s hol d o f def aul t , a s i gni f i cant por t i on o f t he p a y me n t s on a f i v e - y e a r l e a s e
ar e r e qui r e d u p - f r o n t i n or de r t o j u s t i f y c h a r g i n g t he r i s kl e s s rent . For l e s s e e s
f a r f r o m t he de f a ul t b o u n d a r y , a l mo s t no p r e p a y me n t is r equi r ed. I n addi t i on,
t he c o n v e x i t y o f t he c u r v e s ugge s t s t hat t he p r e p a y me n t p e r i o d is mo s t s ens i -
t i ve f or l e s s e e s wi t h hi gh cr edi t ri sk. Thi s wo u l d s ugge s t t ha t v a r i a t i o n s a c r o s s
p r e p a y me n t pe r i ods s houl d be mo r e p r o n o u n c e d wi t h l e s s e e s a p p r o a c h i n g ' j u n k '
qual i t y cr edi t r at i ngs . I n addi t i on, as t he vol a t i l i t y o f t he l e s s e e ( a x ) i nc r e a s e s ,
t he r e qui r e d p r e p a y me n t pe r i od i ncr eas es .
6 . T h e v a l u a t i o n o f l e a s e c r e d i t i n s u r a n c e a n d g u a r a n t e e s
Ma n y t y p e s o f i ns ur a nc e ar e a va i l a bl e f or l eas e t r ans act i ons . On e pa r t i c ul a r
f or m o f i ns ur a nc e t hat p r o v i d e s a di r ect me a n s o f e l i mi n a t i n g or l e s s e ni ng de f a ul t
r i s k i s cr edi t i ns ur ance. Le a s e cr edi t i ns ur a nc e pr ot e c t s t he l essor , pa r t i a l l y or
S. R. Grenadi er~Journal o1' Financial Economi cs 42 ( 1996) 333 3 6 4 3 5 1
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 lease-backed 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 monet ary sums due to the landlord.'
Lease credit insurance is important in a recent, but growing area of financial
markets: lease-backed securities (LBS). LBS are similar to standard asset-backed
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 mid-sized leasing companies in
the private-placement market. Similar to other asset-backed securities, LBS can
involve insurance against credit loss in the form of credit-enhancement 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 default-free.
The equilibrium lease model in this paper can be applied to an analysis of
credit insurance. Consider a T-year 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 securi t y' 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( / *) , T - t * ] , 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 2 I "~ "~
c,~ (S, t)S 7'ss + f~(S, x, t )o~(S, t )ox(x, t )SXq'sx + ~ or; (x, t ) x - ~vx
+z~,,(S,t)SCPs + ~,(X,t)Xq~x + ~P, riP, (20)
352 S, R. Grenadier / Journal of Financial Economics 42 (1996) 333~.364
Val ue o f Insurance Contract
40
30 ~....~ ,/= 1
20 = . 8 5
10
I , I I , I
1.125 1.25 1.375 1.5
X/ K
Fig. 4. The e qui l i br i um val ue o f cr edi t r i sk i nsur ance.
Thi s f i gur e s hows t he effect o f changes i n t he l evel o f i ns ur ance (7) and t he cur r ent di s t ance t:om
def aul t (X/ K) on t he val ue o f a cr edi t r i s k i nsur ance pol i cy. A cr edi t r i s k i ns ur ance pol i cy pr omi s e s
t he hol der of t he l eas e a pa yout o f at l east a f r act i on ?, of t he va l ue of t he r e ma i ni ng cont r act ual
l ease payment s . Thr ee cur ves pl ot t he effect o f i nc r e a s i ng di s t ance f r om def aul t on t he e qui l i br i um
i ns ur ance pr e mi um: t he l op cur ve i s for a f ul l y i nsur ed cont r act , t he mi ddl e cur ve i s for a cont r act
promising 85% cover age, and t he bottom cur ve i s for a cont r act pr omi s i ng 70% cover age. For each
l evel o f i nsur ance 7,, i ncr eas i ng t he di s t ance f r om def aul t l eads t o a decr eas e in t he i ns ur ance pr e mi um.
However , t he di f f er ence in pr i c i ng i s onl y si gni f i cant for t he mos t r i s ky l eases. The def aul t par amet er
va l ue s ar e ~,. 0, c~ = 0. 02, ~r~. = 0.15, aa 0.15, p = 0.5, r = 0. 05, co = 0. 2, T = 5, and
S = I O.
subject to the boundary conditions
, v ( s , x , T ; T , ? , ) =o,
~ ( S , K , t ; , T , ? , ) max[ ) ' Pt ( T) ( e - ~ ( r - t ) ) l
= 1 - - ( 1 - ~ ) v ( s , r - t ) , o .
(21)
The first boundary condition ensures that the insurance payment is zero i f there is
no default. The second boundary condition is the insurance payment upon default:
the potential shortfall between the amount recovered and the promised mi ni mum
payout.
The cost of this insurance policy is pai d at t i me 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 present ed i n the Appendi x. This solution can be written as
VJ(&X,0;7",7) B( &X; K0 , 7 , 1 ~,)),
(22)
where the fimction B( S , X; T, y l , Y2, Ys) is defined in the Appendi x.
Fig. 4 plots the effect of changes in the level o f i nsurance (7) and the current
distance frorn default ( X / K) on the value of a credit risk i nsurance pol i cy. Three
curves plot the effect of increasing distance from default on the equilibrium in-
surance premi um: the top curve is for a 100% fully insured cont ract (5, 1), the
middle curve is for a cont ract promi si ng 85% coverage, and the bot t om curve is
for a cont ract promi si ng 70% covcragc. For each level o f i nsurance 7, a great er
distance from default leads to a decrease in the i nsurance premi um. The premi um
is convex in X/ K, meani ng that the effect o f increasing the degree of credit risk
on the val uc of the insurance is most pr onounced for very ri sky leases, in addi-
tion, the i nsurance premi um increases with the level o f insurance. However, the
difference in pricing is onl y signilicant l br the most ri sky leases. As A;/K reaches
around 1.25, the effect of ;' is negligible.
7. Credi t risk and t he opt i on t o purchase
A common clause in leases is fi)r the lessee to have the opt i on to purchasc
thc asset at the end of the term o f the lease for a predet ermi ned price. Mc-
Connel l and Schallheim ( 1983) provi de a val uat i on o f this option. Because the
grant i ng o f such options is valuable, the rental payment s must be adjusted up-
wards.
In the cont ext of credit risk, these purchase opt i ons are especi al l y relevant.
Because these options can be exerci sed onl y at the end of the term, the op-
tions provi de an incentive lk)r thc lessee not to default on the lease. The in-
tensity o f this incentive depends on the attractiveness o f the predet ermi ned ex-
ercise price, t ypi cal l y set at the expect ed value of the underl yi ng asset at the
end o f the lease term. From the vi ewpoi nt o f the lessor, t wo lessees with equal
ex ante credit risk will likely have different ex post lease default realizations
dependi ng on whet her t hey sign a lease with or wi t hout purchase
options.
Consi der the value o f an option to purchase the underl yi ng asset at the end
o f the lease ['or the fixed exercise price of E. This differs f i om a standard call
option in that the option may onl y be exerci sed shoul d the lessee not dethult.
The value o f this option, H( S , X. I ; T, E) , will once again satisfy the fol l owi ng
equilibrium partial differential equation:
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 ) S t t s - ~, (X, t ) XHv + Ht - r H, (23)
354 S. R. Grenadier~Journal of Financial Economics 42 (1996) 333-364
Option Value
40
E = 180 . . . . . . . . . , - . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
- i i i . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
..: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 five-year 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.
subj ect to t he boundar y condi t i ons
H ( S , X , T ; T , E ) = max [ V( S) - E, 0] ,
H ( S , K , g ; T , E ) = 0, ( 24)
wher e V ( S ) is t he val ue of t he under l yi ng asset, as det er mi ned in Eq. (4). The
first boundar y condi t i on is t he call opt i on payof f at mat uri t y. The second boundar y
condi t i on refl ect s t he fact that t he val ue of t he opt i on falls to zero i f t he l essee
defaul t s.
For t he case in whi ch S and X f ol l ow correl at ed geomet r i c Br owni an mot i ons,
a cl osed- f or m sol ut i on to partial differential equat i on (23) subj ect to boundar y
condi t i ons (24) and eval uat ed at t i me t = 0 is der i ved in t he Appendi x.
Fig. 5 pl ot s t he effect of t he ratio of X/ K on t he val ue of t he opt i on to pur chase
for di fferent val ues of t he exer ci se pri ce E. Si nce t he expect ed val ue of t he asset at
t he end of t he l ease t er m is 200, t he mi ddl e curve r epr esent s t he t ypi cal pr ot ocol
of set t i ng t he opt i on exer ci se pri ce equal to t he as s et ' s expect ed t ermi nal value.
S.R. Grenadier/Journal o[ Financial Economics 42 (1996) 333 364 355
For each value of E, the option price increases with the ratio o f X/ K. When
the ratio is unity, the lessee is certain to default, and the opt i on is worthless.
As the ratio rises, the probabi l i t y o f defaul t falls to zero, and the value o f the
purchase opt i on approaches the val ue o f a standard ' no- def aul t ' call opt i on on
the underl yi ng asset. When the l essee' s asset value (or cash fl ow) is reasonabl y
far above the defaul t t ri gger value, the standard ' no- def aul t ' call opt i on value
will be a good approxi mat i on of the lease purchase option. However, when the
l essee' s credit condi t i on is vulnerable, using a st andard call opt i on f or mul a can
be a very poor approxi mat i on. As the exercise price increases, the value o f the
opt i on to purchase falls. When the l essee' s credit condi t i on is hi ghl y vulnerable,
however, the effect o f changes in the exercise price are quite moderat e. Thi s is
because the likelihood of exercise, no matter how attractive the opt i on, falls to
zero due to i mpendi ng default.
In order to derive the equilibrium rent, P"( T) , on a T- year risky lease with
a purchase option, we will use a vari ant o f the standard put call pari t y rela-
tion. It will prove useful to charact eri ze the val ue o f t wo additional contracts.
First, consi der an opt i on t o sell the leased asset at the end o f the lease term,
condi t i onal on no default havi ng occurred. This is si mpl y a put opt i on on the
asset with exercise price E and expiration date T, condi t i onal on no default.
Denot e the val ue o f such a put opt i on as J( S, X, t ; KE) . The val ue of this put
option must satisfy an equi l i bri um partial differential equation, whi ch is pro-
vi ded in the Appendi x. Second, let N( X, t ; T) denot e the value o f a zer o- coupon
bond whi ch pays $1 at time T onl y i f there is no default. The value o f this
bond will satisfy an equi l i bri um partial differential equation, also provi ded in the
Appendi x.
Now, we can det ermi ne the equi l i bri um rent, P~'(T), on a T-year ri sky lease
with a purchase option. As usual, I will present t wo equi val ent met hods o f selling
the use o f the asset. The first met hod of selling the use o f the asset is to si mpl y
lease the asset for T years under a lease with a purchase option. I f the lessee
defaults, then the lessor re-leases the asset for the remai nder o f the t erm (after de-
duct i ng a credit l oss) to a riskless lessee. Under this leasing pol i cy, the l essor sells
the use o f the asset for T years and recei ves E - V[ S( T) ] in year T i f the opt i on
is exerciscd. The value of this port fol i o is F[ S, K, t ; P ( T) , T] H( S, X, t ; KE) .
The second met hod is for the lessor to form the f ol l owi ng portfolio: sell thc
use of the asset for T years by leasing to a riskless lessee, purchase E zero-
coupon bonds payi ng $1 at time T onl y i f no default occurs, write an opt i on
to sell the asset at time T for $E where the option may onl y be exerci sed i f
no default occurs, and write an opt i on to purchase the asset at time T for $0
where the option may onl y be exerci sed i f no default occurs. The value o f this
port fol i o is Y(S, T) + E,~(X,t; T) - J ( &X , t ; T, E) - J ( S , X , t ; K0) . The payof f o f
this port fol i o is preci sel y that o f the first met hod: the lessor recei ves payment s
for selling the use of the asset for T years plus a payment of E - V[S(T)] in
year T i f the opt i on is exercised.
356 X R. Gremtdier/.lourna/ of Fimmcial Economics 42 (1996) 333 364
Since both o f these met hods of leasing produce identical payoffs, the lease rate
p0( T) must bc set at time zero to cquat e their values. Thus, in equi l i bri um P" ( T)
must be set to satisfy the fol l owi ng condi t i on:
Fi X, K, i; i f ' ( r ) , T] - H ( S , X , t; r , E )
- - Y ( S , T ) +E N ( X , t ; T ) - J ( S , X , t ; T , E ) J ( S , X , t ; T , O) . (25)
Al t ernat i vel y, tbr a gi ven (hi gher) rent P ( T ) , it is simple to solve for the equi-
librium exercise price, E, on the embcdded call option.
8. Percent age l eases and credit risk
In the U.S., the percent age lease is the domi nant met hod o f leasing retail space
in shoppi ng malls. This is clearly an i mport ant sect or of the leasing lnarket, with
al most 38, 000 shoppi ng centers in the U.S. account i ng for over $700 billion
in retail sales in 1991 ( Shoppi ng Cent er Directions, 1992). The rents paid by
different classes o f mall tenants vary substantially. In 1992, the medi an rent per
square l oot paid by depart ment stores in super regional shoppi ng malls was S1.95
(Dol l ars and Cent s o f Shoppi ng Centers, 1993). For home furnishing stores thc
median rent was $25, and lbr j ewel r y stores the medi an rent was $42. In addi-
tion, the average rent per square foot for stores that were members of national
chains was onl y around hal f as high as that lbr independent stores. Undcr a
percent age leasc, the shoppi ng cent er owncr collects a fixed base rent plus a
pcrcent agc o f the st or e' s sales, provi ded the st or e' s sales exceed a gi ven thresh-
old. In a default-li"ee context, such cont ract s have been anal yzed by Bcnjanlin,
Boyle, and Si nnans ( 1990) and Grenadi er (1995). Because percent age leases
are most coi nmon on the smaller mall shops, thc i mpact o f credit risk may be
considerable.
Percent age leases are a special case o f a more general form of leasing structure
in whi ch rent is tied to some measure o f the intensity o f an asset ' s use. Ex-
ampl es inchide car leasc rates linked to mileage, copy machi ne rents linked to
the numbcr of copies, and comput er leases linked to CPU cycles. Smith and
Wakel nan ( 1985) provi de a di scussi on o f the rationale underl yi ng such leasing
arrangement s.
The model can be applied to val uc the percent age lease under condi t i ons o f
potential default. The cont ract specifies a base rent, R s~, whi ch must be paid
regardless o f sales performance. In addition, shoul d sales rise above a t hreshol d
~, a percent age p o f the level o f sales above the t hreshol d is paid to the landlord.
Assume that the st or e' s sales are proport i onal to the asset value o f the space,
i<. V [S(I)]. Thus, the lease payment (fl ow) made at time 1, Rl ' ( t ) , cont i ngent on
S.R. Grenadier / Journal of Financial Economics 42 (1996) 333 364 357
no default having occurred, is
RP( t ) =R B +max 100"
[ = Re + 100 " max V[S(t)] - ~c
The rental payment on a percentage lease (contingent on no default having
occurred) is equal to the sum of a fixed payment, R e, 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 closed-form 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 R B, plus the time-integral (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 T-year percentage lease, as of time t - 0, is
LP( S' X' O; T' p' R~' S) F( S ' X' O; RS ' T) + 1 0 0 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 T-year riskless lease, Y( S, T) . Therefore, equilibrium combinations of
( p, R~, S) are solutions to the following equality:
(28) Y(S, T) -- LP(&X,O; T, p, Rg, S ) .
9. Conclusion
1 derive a model that provides a unified approach to the equilibrium valuation of
leases subject to default risk. Using an option-pricing 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, up-front prepayments,
lease credit insurance contracts, embedded lease purchase options, and percentage
leases.
358 S. R. Grenadi er~Journal o]" Financial Economi cs 42 ( 1996) 3 3 3 ~ 6 4
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 val ue) 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 l essee' 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.
A p p e n d i x
A. 1. Ex p l i c i t s ol ut i ons j o r l ease c o n t r a c t s
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.,
d S - ~, , , Sdt + a, S dz, , ,
d X - ~. , Xdt + a x Xd z , - ,
(29)
and where p is the instantaneous correlation coefficient between the Wiener pro-
cesses dz, and dz.,.. Under this specification, S ( t ) and X ( t ) will be log-normal
random variables.
The r i s kh, s s h' ase
Eq. (2) defines the value of a T-year riskless lease by the function Y( S, T) .
Using the properties of log-normal variables, the expected value of the integral
can be written as
S [1 e ( r x, .
Y( S, T) - )r] (30)
F 3~
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
1 - e - ( ' - ~ ' i r ) r S 1
R( r ) ] --~V~- I , . - ~ , ( 3
)
S . R . G r e n a d i e r / J o u r n a l o.1 F i n a n c i a l E c o n o m i c s 4 2 ( 1 9 9 6 ) 3 3 3 3 6 4 3 5 9
The value o f a risk),, T- year lease
In Eq. ( 12) , a f or mul a f or t he va l ue o f a T- y e a r l ease is de not e d b y t he f unct i on
F( S , X, t ; P, T) . Th e expl i ci t s ol ut i on is
P - - (32)
F( S , X, t ; P, T) Vbl (P, r) - cb2(X, r). - + q ) 3 ( X, z ) - ( 1 co) S
F F ~
whe r e
P [ I e - ' ~]
~( P' ~) = 7
q~2(X, z ) = G(X, z, a2 ) - e- r~G( X, ~, al ),
qo3(X, z) G( X, r, aa) - e - 0 ~')TG(X, r, a3) ,
G ( X , T , y ) = N [ I n ( K / X ) - - y . z '" ~ [ I n ( K / / X ) + y . r
L a ~x / f f + , N k '
a 2 a l
C I 0-.~
O 4 - - a 3
C2 0" 2
I 2
a l = ~. v - - ~ 0 - x ,
a2 = { a ~ + 2r0-{ ,
I 2
a 3 = Y.v 4 - pCi x0- s - - ~0-x- ,
a 4 = a? + 2 ( r - ~ , ) a ~ ,
r = T t ,
and whe r e N( - ) de not e s t he c umul a t i ve st andar d nor mal di s t r i but i on f unct i on.
The equi l i bri um securi t y deposi t
Th e s ol ut i on t o di f f er ent i al equat i on ( 16) s ubj ect t o bounda r y c ondi t i ons ( 17) ,
W( S , X , t ; P r).. T, M) , e va l ua t e d at t i me t = 0, can be wr i t t en as
W( S, X, O; P z~, T . M) = F( S, X, O; pD, T) + m . Q(X, T) - B( S, X; T, M, O,o) ,
( 3 3 )
360 S.R. Grenadier~Journal of Financial Economics 42 (1996) 333 364
w h e r e
[ B( S , X; T , ) h , y 2 , y 3 ) b( S, X, T, y l , Y2, Y3, v ) d v ,
b(X,X~ L J,'~, y2, y3, v) = e-r~ O(X, v) [ b , ( S, X, T, >,1, y 2 , Y3, v )
- b 2 ( &X , T, ) h , Y2, Y3, v ) ] ,
)1]
Y l , Y2, y 3 , v ) = K ~: e x p [pz(S, X, v ) + a ~ ( t : ) 2] b2(S, X, 7",
"./2 ( T , ) ' 3 , g' ) N I n ~ ( T , ya, ~OK7 /
- ~ . ( s , x , ~ , ) - ~ ( v ) 2 ) 1 J
f I ( T , y l , Y 2 , v ) = e r " )'1 q- ) ' 2 e r r
r
f 2 ( T , ) ' 3 , t ' ) - - - - ) ; 3 [ l - e {r ~, )(T ~,)] ,
g(X, ~) - l n ( ~ ' / K ) [ ( I n ( X / K ) _ +
u) 2
Hi
e x p [ - 2 a . ~ t ; '
1 2
a l ~ gv ~ O'r ,
, , = ( S , X , t : ) : l n ( S ) _ ) ~ l n ( X ) + [ e , , - a : / / 2 2 @ , - 4 , / ' 2 ) ] , , ,
F 3~ s ' '
& R. Gremt di ert Journal o!' Fi mmci al Economi cs 42 ( 1990) 333 364 361
F
(< a : ( ~: ) }, ,
;. = pa.~/c*~.
The val ue q l ' a h , a s u cr edi t i nsur ance c ont r ac t
The solution to partial differential equation (20) subject to boundary conditions
( 2 1 ) 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 r i s k y lease
In S e c t i o n 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 I t : ( T ) + a~(T),,,'2
x [ ~ ( 2 a ~ , O , a ~ ( T ) , T , E )
-,/J ().~, - 2 1 n ( X / ' K ) a : ( T ) , T , E ) ]
_ E / ~ T e x p [ (2r~+~ t~2)T]
2o-~ J
[ ( - 2 I n ( X / K )
O ( O , O , O , T , E ) - ~ 0, rr~v~
where
I//(YI'Y2 Y3 T ' E ) = a " ' / T e x P [( ( # - arYl) X/-f
[ h ( Y l , 3'2, Y3,
x N 2 T , E ) ,
In(X/K) (# - y, )
O-.-~ N / ~ O-x
(2ra~ +/ , 2) T]
2 0 - ? ]
I 2
Y2 i ) ' 2
+ y2, ~'( T)]
362 S. R. Grem, dier/ Journal {~f Financial Economics 42 ( 1996 ) 333 364
h( yl v2,Ys, T , E ) = ( t & ( T )
In(E//X ~- )
' - ~ ( > 7
+)' 3 /~ ~ "
V % ( T ) o-,
x ~ ( 1 - v ( T ) 2 ) ,
;,~x , / v
v ( T ) -
, / ~ ( T ) + ~ : ~ T '
2 = pa.~./ax,
la a2/ 2 ~,~,
( S ) [~-,,, a.2/2 )~(~-x a ~ / 2 ) ] T
p : ( T ) In ~ - 21n(X) + - - - ,
a . ( T ) = ~ / ( a 2 - ~o2a 2) T,
and N2( x l , x 2, 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. Val uat i on o f ' de f aul t - c ont i nge nt ' p u t opt i on a n d z e r o- c oupon b o n d
In Section 7, J ( S , X , t ; T , E ) 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:
1 O " ; '
0 la2(S,t)S2Jss + p ( S , X , t ) a , . ( S , t ) a , ( X , t ) S X J s x + 7a~( X, t ) X"JA;
+z(~.(S,t)SJs + ~ x ( X, t ) XJ x +.]1 - r J ,
subject to the boundary conditions
(36)
J ( S , X . 7"; T , E ) = max [E - V(S), 0] ,
J ( X K , 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. Grenadi er / J o u r md q/ ' Fi nanc i al Ec onomi c s 42 ( 1996) 333 364 363
Th e v a l u e o f a z e r o - c o u p o n b o n d wh i c h p a y s $1 at t i me T o n l y i f t h e r e i s no
d e f a u l t i s d e n o t e d as N ( X , t ; T ) . Th e v a l u e o f t h i s b o n d wi l l s a t i s f y t he f o l l o wi n g
e q u i l i b r i u m par t i al di f f e r e nt i a l e q u a t i o n :
1 2 - - : t x , : 2 r , r
0 ~rTxI, A , ) A ~'~a" + ~ . v ( X , t ) X N x + N t - - r N , (38)
s u b j e c t t o t he b o u n d a r y c o n d i t i o n s
N(X, T; T) -- I,
N( K, t ; T) = O.
( 3 9 )
Th e f i r st b o u n d a r y c o n d i t i o n i s t he b o n d p a y o f f at ma t u r i t y . Th e s e c o n d b o u n d a r y
c o n d i t i o n r e f l e c t s t he f a c t t ha t t he v a l u e o f t he b o n d f al l s t o z e r o s h o u l d t he l e s s e e
de f a ul t .
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