Estimating Market Leverage : Maximum Likelihood and Kalman Filter

Market leverage is one of the main determinants for defining the optimal capital structure of the firm, and has a significant impact on several variables that affect the design of the firm's business strategy. This paper is focussed on the potential methodologies exploitable to obtain reliable estimates of the firm's market leverage. This is a relevant issue as many factors make obscure the actual dynamics of the firm's leverage. We estimate the unknown parameters that determine the stochastic properties of the unobservable variable, by using maximum likelihood estimation and the Kalman filter approach. The starting point of our analysis is the seminal Merton model (1974), which describes the firm's asset value dynamics with a pure diffusion process, improved with the early default risk as proposed by Duan et al. (2003). We report the simulation results for different possible estimation methods, and then perform an empirical analysis on real data of 25 European companies CDS premia