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When does Strategic Debt-service Matter?

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  • Viral Acharya

    ()

  • Jing-zhi Huang

    ()

  • Marti Subrahmanyam

    ()

  • Rangarajan Sundaram

    ()

Abstract

Recent work has suggested that strategic underperformance of debt-service obligations by equity holders can resolve the gap between observed yield spreads and those generated by Merton-style models. We show that this is not quite correct. The value of the option to underperform on debt-service obligations depends on two other optionalities available to equity holders, namely, the option to carry cash reserves within the firm and the option to raise new external financing. We disentangle the effects of the three factors, and characterize the impact of each in isolation as well as their interaction. We find, among other things, that while strategic behavior can increase spreads significantly under some conditions, its impact is negligible in others, and in some cases it even leads to a decline in equilibrium spreads. We show that this last apparently paradoxical result is a consequence of an interaction of optionalities that results in a trade-off between strategic and liquidity-driven defaults.

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Bibliographic Info

Article provided by Springer in its journal Economic Theory.

Volume (Year): 29 (2006)
Issue (Month): 2 (October)
Pages: 363-378

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Handle: RePEc:spr:joecth:v:29:y:2006:i:2:p:363-378

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Related research

Keywords: Strategic debt-service; Optimal cash management; Liquidity defaults; Strategic defaults; Yield spreads; G13; G33; G35;

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References

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  1. Oliver Hart & John Moore, 1997. "Default and Renegotiation: A Dynamic Model of Debt," STICERD - Theoretical Economics Paper Series /1997/321, Suntory and Toyota International Centres for Economics and Related Disciplines, LSE.
  2. Viral Acharya & Jing-zhi Huang & Marti Subrahmanyam & Rangarajan Sundaram, 2006. "When does Strategic Debt-service Matter?," Economic Theory, Springer, vol. 29(2), pages 363-378, October.
  3. Mella-Barral, Pierre & Perraudin, William, 1997. " Strategic Debt Service," Journal of Finance, American Finance Association, vol. 52(2), pages 531-56, June.
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Citations

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Cited by:
  1. Biais, Bruno & Mariotti, Thomas & Plantin, Guillaume & Rochet, Jean-Charles, 2004. "Dynamic Security Design: Convergence to Continuous Time and Asset Pricing Implications," IDEI Working Papers 312, Institut d'Économie Industrielle (IDEI), Toulouse, revised Sep 2006.
  2. Anderson, Ronald W & Carverhill, Andrew, 2005. "A Model of Corporate Liquidity," CEPR Discussion Papers 4994, C.E.P.R. Discussion Papers.
  3. Georges Dionne & Sadok Laajimi, 2009. "On the Determinants of the Implied Default Barrier," Cahiers de recherche 0914, CIRPEE.
  4. Alon Raviv, 2004. "Bank Stability and Market Discipline: Debt-for-Equity Swap versus Subordinated Notes," Finance 0408003, EconWPA.
  5. Jean Marc Bourgeon & Georges Dionne, 2013. "On debt service and renegotiation when debt-holders are more strategic," Working Papers 191200, Institut National de la Recherche Agronomique, France.
  6. Viral V. Acharya & Sergei A. Davydenko & Ilya A. Strebulaev, 2011. "Cash Holdings and Credit Risk," NBER Working Papers 16995, National Bureau of Economic Research, Inc.
  7. Anderson, Ronald W & Carverhill, Andrew, 2007. "Liquidity and Capital Structure," CEPR Discussion Papers 6044, C.E.P.R. Discussion Papers.
  8. Cangemi, Robert R. & Mason, Joseph R. & Pagano, Michael S., 2012. "Options-based structural model estimation of bond recovery rates," Journal of Financial Intermediation, Elsevier, vol. 21(3), pages 473-506.
  9. Heitor Almeida & Murillo Campello & Michael S. Weisbach, 2002. "Corporate Demand for Liquidity," NBER Working Papers 9253, National Bureau of Economic Research, Inc.
  10. Viral Acharya & Jing-zhi Huang & Marti Subrahmanyam & Rangarajan Sundaram, 2006. "When does Strategic Debt-service Matter?," Economic Theory, Springer, vol. 29(2), pages 363-378, October.
  11. Ilya A. Strebulaev, 2007. "Do Tests of Capital Structure Theory Mean What They Say?," Journal of Finance, American Finance Association, vol. 62(4), pages 1747-1787, 08.
  12. R. Jarrow & A. Purnanandam, 2007. "The valuation of a firm’s investment opportunities: a reduced form credit risk perspective," Review of Derivatives Research, Springer, vol. 10(1), pages 39-58, January.
  13. Pawlina, Grzegorz, 2010. "Underinvestment, capital structure and strategic debt restructuring," Journal of Corporate Finance, Elsevier, vol. 16(5), pages 679-702, December.
  14. Gryglewicz, Sebastian, 2011. "A theory of corporate financial decisions with liquidity and solvency concerns," Journal of Financial Economics, Elsevier, vol. 99(2), pages 365-384, February.
  15. Linda Allen & Anthony Saunders, 2004. "Incorporating Systemic Influences Into Risk Measurements: A Survey of the Literature," Journal of Financial Services Research, Springer, vol. 26(2), pages 161-191, October.

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