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Funding Liquidity, Debt Tenor Structure, and Creditor's Belief: An Exogenous Dynamic Debt Run Model

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  • Gechun Liang
  • Eva L\"utkebohmert
  • Wei Wei

Abstract

We propose a unified structural credit risk model incorporating both insolvency and illiquidity risks, in order to investigate how a firm's default probability depends on the liquidity risk associated with its financing structure. We assume the firm finances its risky assets by issuing short- and long-term debt. Short-term debt can have either a discrete or a more realistic staggered tenor structure. At rollover dates of short-term debt, creditors face a dynamic coordination problem. We show that a unique threshold strategy (i.e., a debt run barrier) exists for short-term creditors to decide when to withdraw their funding, and this strategy is closely related to the solution of a non-standard optimal stopping time problem with control constraints. We decompose the total credit risk into an insolvency component and an illiquidity component based on such an endogenous debt run barrier together with an exogenous insolvency barrier.

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File URL: http://arxiv.org/pdf/1209.3513
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Paper provided by arXiv.org in its series Papers with number 1209.3513.

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Date of creation: Sep 2012
Date of revision: Sep 2013
Handle: RePEc:arx:papers:1209.3513

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Web page: http://arxiv.org/

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  1. Leland, Hayne E, 1994. " Corporate Debt Value, Bond Covenants, and Optimal Capital Structure," Journal of Finance, American Finance Association, American Finance Association, vol. 49(4), pages 1213-52, September.
  2. Bianca Hilberink & L.C.G. Rogers, 2002. "Optimal capital structure and endogenous default," Finance and Stochastics, Springer, Springer, vol. 6(2), pages 237-263.
  3. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
  4. Leland, Hayne E & Toft, Klaus Bjerre, 1996. " Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads," Journal of Finance, American Finance Association, American Finance Association, vol. 51(3), pages 987-1019, July.
  5. Hayne E. Leland, 1998. "Agency Costs, Risk Management, and Capital Structure," Journal of Finance, American Finance Association, American Finance Association, vol. 53(4), pages 1213-1243, 08.
  6. Wei Xiong & Zhiguo He, 2010. "Rollover Risk and Credit Risk," 2010 Meeting Papers, Society for Economic Dynamics 98, Society for Economic Dynamics.
  7. Olivier Renault & Jan Ericsson, 2000. "Liquidity and Credit Risk," FMG Discussion Papers, Financial Markets Group dp362, Financial Markets Group.
  8. Tobias Adrian & Hyun Song Shin, 2008. "Liquidity and leverage," Staff Reports, Federal Reserve Bank of New York 328, Federal Reserve Bank of New York.
  9. Merton, Robert C., 1973. "On the pricing of corporate debt: the risk structure of interest rates," Working papers, Massachusetts Institute of Technology (MIT), Sloan School of Management 684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  10. Ing-Haw Cheng & Konstantin Milbradt, 2012. "The Hazards of Debt: Rollover Freezes, Incentives, and Bailouts," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 25(4), pages 1070-1110.
  11. Itay Goldstein & Ady Pauzner, 2005. "Demand-Deposit Contracts and the Probability of Bank Runs," Journal of Finance, American Finance Association, American Finance Association, vol. 60(3), pages 1293-1327, 06.
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