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A Note on Financial Frictions and Risky Corporate Debt in Relation to Cooley and Quadrini (2001)

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Author Info
Doriana Ruffino () (Boston University, Department of Economics)
Jonathan Treussard () (Boston University, Department of Economics)

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Abstract

We o¤er clari?cations on Cooley-Quadrini (2001) as regards ?nancial frictions and risky corporate-debt pricing. Even in a frictionless world, the promised rate on corpo- rate debt is not identical across ?rms and across capital structures and it is not equal to the risk-free market interest rate. Frictions are unnecessary for credit spreads to arise. Only with risk-neutrality at the macro-level do interest rates on corporate debt re?ect default-probabilities and in general, assuming that lenders set interest rates re- ?ecting their personal risk-neutrality systematically biases promised rates relative to market-based rates. To the extent that the ?rm?s entire ?nancial structure is traded in ?nancial markets, this bias introduces an exploitable arbitrage opportunity.

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Paper provided by Boston University - Department of Economics in its series Boston University - Department of Economics - Working Papers Series with number WP2006-017.

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Length: 12 pages
Date of creation: Mar 2006
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Handle: RePEc:bos:macppr:wp2006-017

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  1. Cox, John C. & Ross, Stephen A. & Rubinstein, Mark, 1979. "Option pricing: A simplified approach," Journal of Financial Economics, Elsevier, vol. 7(3), pages 229-263, September. [Downloadable!] (restricted)
  2. Thomas F. Cooley & Vincenzo Quadrini, 2001. "Financial Markets and Firm Dynamics," American Economic Review, American Economic Association, vol. 91(5), pages 1286-1310, December. [Downloadable!] (restricted)
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  3. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-70, May. [Downloadable!] (restricted)
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