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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. Hayne E. Leland., 1998. "Agency Costs, Risk Management, and Capital Structure," Research Program in Finance Working Papers, University of California at Berkeley RPF-278, University of California at Berkeley.
  2. Olivier Renault & Jan Ericsson, 2000. "Liquidity and Credit Risk," FMG Discussion Papers dp362, Financial Markets Group.
  3. Merton, Robert C., 1973. "On the pricing of corporate debt: the risk structure of interest rates," Working papers 684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  4. Hayne E. Leland., 1994. "Corporate Debt Value, Bond Covenants, and Optimal Capital Structure," Research Program in Finance Working Papers, University of California at Berkeley RPF-233, University of California at Berkeley.
  5. Zhiguo He & Wei Xiong, 2012. "Rollover Risk and Credit Risk," Journal of Finance, American Finance Association, vol. 67(2), pages 391-430, 04.
  6. Hayne E. Leland and Klaus Bjerre Toft., 1995. "Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads," Research Program in Finance Working Papers, University of California at Berkeley RPF-259, University of California at Berkeley.
  7. Adrian, Tobias & Shin, Hyun Song, 2010. "Liquidity and leverage," Journal of Financial Intermediation, Elsevier, vol. 19(3), pages 418-437, July.
  8. Ing-Haw Cheng & Konstantin Milbradt, 2012. "The Hazards of Debt: Rollover Freezes, Incentives, and Bailouts," Review of Financial Studies, Society for Financial Studies, vol. 25(4), pages 1070-1110.
  9. 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.
  10. Itay Goldstein & Ady Pauzner, 2005. "Demand-Deposit Contracts and the Probability of Bank Runs," Journal of Finance, American Finance Association, vol. 60(3), pages 1293-1327, 06.
  11. Bianca Hilberink & L.C.G. Rogers, 2002. "Optimal capital structure and endogenous default," Finance and Stochastics, Springer, vol. 6(2), pages 237-263.
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