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Belief updating, debt pricing and financial decisions under asymmetric information

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  • Xu, Ruxing
  • Li, Shenghong
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    Abstract

    This paper studies debt holders' belief updating, valuation of corporate debt, and equity owners' financing decisions during financial distress under asymmetric information. This is done within a continuous-time framework, where the relevant state variable is assumed to follow an Arithmetic Brownian motion (ABM). ABM can take negative values and has very realistic feature compared with Geometric Brownian motion (GBM). Using Chapter 11 of U.S. Bankruptcy Code as a costly screening device, we can characterize which firm will choose private workouts (in the form of strategic debt service) and which will choose to file for the Chapter 11 Bankruptcy procedure (in the form of debt-equity swap) when the firm is in financial distress. Using arguments similar to equilibrium refinements, we give a clear picture of how debt holders' beliefs about the firm's types are updated according to the state variable and the firm's default behavior, and describe optimal strategies of both parties under those beliefs. We also provide an approximate solution to the debt pricing problem under asymmetric information.

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    Bibliographic Info

    Article provided by Elsevier in its journal Research in International Business and Finance.

    Volume (Year): 24 (2010)
    Issue (Month): 2 (June)
    Pages: 123-137

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    Handle: RePEc:eee:riibaf:v:24:y:2010:i:2:p:123-137

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    Web page: http://www.elsevier.com/locate/ribaf

    Related research

    Keywords: Asymmetric information Belief updating Capital structure Debt valuation Financial decisions;

    References

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    Cited by:
    1. Shibata, Takashi & Tian, Yuan, 2012. "Debt reorganization strategies with complete verification under information asymmetry," International Review of Economics & Finance, Elsevier, vol. 22(1), pages 141-160.

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