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A Model of Credit Risk, Optimal Policies, and Asset Prices

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Author Info

  • Suleyman Basak

    (London Business School)

  • Alexander Shapiro

    (Stern School of Business, New York University)

Abstract

This article studies an economy with borrowers (firms or individuals) under costly default. Borrowers defaulting under adverse economic conditions may, despite incurring default costs, emerge as wealthier than nonborrowers. Asset substitution is generally not pronounced, although a larger risk exposure by borrowers may also occur, and then binary options emerge as useful credit derivatives. The asset-value dynamics are endogenously determined and shown to exhibit stochastic mean and volatility, in contrast to many credit risk models. In equilibrium, the market level is increased (decreased) in economic downturns (upturns) by the presence of credit risk.

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Bibliographic Info

Article provided by University of Chicago Press in its journal Journal of Business.

Volume (Year): 78 (2005)
Issue (Month): 4 (July)
Pages: 1215-1266

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Handle: RePEc:ucp:jnlbus:v:78:y:2005:i:4:p:1215-1266

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Web page: http://www.journals.uchicago.edu/JB/

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Cited by:
  1. Colonnello, Stefano & Curatola, Giuliano & Ngoc Giang Hoang, 2014. "Executive compensation structure and credit spreads," SAFE Working Paper Series 60, Research Center SAFE - Sustainable Architecture for Finance in Europe, Goethe University Frankfurt.
  2. Li Chen & H. Vincent Poor, 2003. "Information Asymmetry, Corporate Debt Financing and Optimal Investment Decisions: A Reduced Form Approach," Finance 0312008, EconWPA.

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