The Realized Sharpe Ratio and Uncertainty of Firm Earnings Distribution (Starting with Modigliani Miller)

Abstract

Equity and credit are options on firm assets. As options, actual returns to equity and credit are functions of two distinct sources of value; 1) expected firm asset returns and 2) the difference between option price implied and subsequent realized firm asset volatility. Equity and credit are subject to option value arbitrage pricing and therefore no compensating returns accrue to equity and credit for stochastic firm asset volatility. Portfolio construction that eliminates the capital structure option exposure will increase realized risk adjusted returns relative to investments with capital structure option exposure.