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The Hazards of Debt: Rollover Freezes, Incentives, and Bailouts

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  • Ing-Haw Cheng
  • Konstantin Milbradt

Abstract

We investigate the trade-off between incentive provision and inefficient rollover freezes for a firm financed with short-term debt. First, debt maturity that is too short-term is inefficient, even with incentive provision. The optimal maturity is an interior solution that avoids excessive rollover risk while providing sufficient incentives for the manager to avoid risk-shifting when the firm is in good health. Second, allowing the manager to risk-shift during a freeze actually increases creditor confidence. Debt policy should not prevent the manager from holding what may appear to be otherwise low-mean strategies that have option value during a freeze. Third, a limited but not perfectly reliable form of emergency financing during a freeze--a "bailout"--may improve the terms of the trade-off and increase total ex ante value by instilling confidence in the creditor markets. Our conclusions highlight the endogenous interaction between risk from the asset and liability sides of the balance sheet. The Author 2011. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com., Oxford University Press.

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Bibliographic Info

Article provided by Society for Financial Studies in its journal Review of Financial Studies.

Volume (Year): 25 (2012)
Issue (Month): 4 ()
Pages: 1070-1110

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Handle: RePEc:oup:rfinst:v:25:y:2012:i:4:p:1070-1110

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Cited by:
  1. Philipp König & David Pothier, 2014. "Asymmetric Information and Roll-Over Risk," Discussion Papers of DIW Berlin 1364, DIW Berlin, German Institute for Economic Research.
  2. Jaromir Nosal & Guillermo Ordoñez, 2013. "Uncertainty as commitment," National Bank of Poland Working Papers 141, National Bank of Poland, Economic Institute.
  3. Duchin, Ran & Sosyura, Denis, 2014. "Safer ratios, riskier portfolios: Banks׳ response to government aid," Journal of Financial Economics, Elsevier, vol. 113(1), pages 1-28.
  4. N. Letifi & J.-L. Prigent, 2014. "On the debt capacity of growth and decay options," Working Papers 2014-391, Department of Research, Ipag Business School.
  5. Zhiguo He & Konstantin Milbradt, 2012. "Endogenous Liquidity and Defaultable Bonds," NBER Working Papers 18408, National Bureau of Economic Research, Inc.
  6. Konstantin Milbradt & Martin Oehmke, 2014. "Maturity Rationing and Collective Short-Termism," NBER Working Papers 19946, National Bureau of Economic Research, Inc.
  7. Gechun Liang & Eva L\"utkebohmert & Wei Wei, 2012. "Funding Liquidity, Debt Tenor Structure, and Creditor's Belief: An Exogenous Dynamic Debt Run Model," Papers 1209.3513, arXiv.org, revised Sep 2013.
  8. Admati, Anat R. & DeMarzo, Peter M. & Hellwig, Martin F. & Pfleiderer, Paul, 2010. "Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity Is Not Expensive," Research Papers 2065, Stanford University, Graduate School of Business.
  9. Thomas M. Eisenbach, 2013. "Rollover risk as market discipline: a two-sided inefficiency," Staff Reports 597, Federal Reserve Bank of New York.
  10. Konstantin Milbradt & Zhiguo He, 2012. "Endogenous liquidity and defaultable bonds," 2012 Meeting Papers 86, Society for Economic Dynamics.

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