Hi
@nansverma Yes, I think you are right to be puzzled by Stulz: we've had to contend with contradictions surfaced in Chapter 18 for a decade; e.g, see
https://www.bionicturtle.com/forum/threads/interest-rates-stultz.10689/post-52227 There are a few problems, but in my opinion, your point speaks to the difference between his theoretical-model approach and his empirical statements (compounded by writing that is notoriously difficult to decipher). The fundamental idea of his his credit risk chapter is option-pricing-model-based and therefore purely theoretical. The theory includes that equity is a call option on the firm's assets and, under this pure model, an increase in the interest rate implies an increase in equity value (i.e., an increase in the riskfree rate increases the value of an option).
However, he also says that "empirical evidence suggests that stock prices are negatively correlated with interest rates." And, as an equity investor, I can tell you this tends to be true a lot! (in just the last two months, equity prices have been greatly influenced by the Fed's statements about possible rate hikes). This empirical evidence is based in a simple idea: higher interest rates imply a higher discount rate on future earnings/cash flows and therefore a lower present value of the equity claim. Further, in Stulz option-based approach, a higher rate of course lowers the present value of debt, such that, given a certain firm value, lower debt will increase the residual equity claim! I simply do not see Stulz reconcile these two approaches. I can try to say (and I have said) that it's a case of theoretical-model (i.e., BSM) versus empirical observation, but the slight problem there is that, you can see, he also employs models that can contradict with respect to interest rate interactions. I hope that's helpful, thanks!
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