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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)

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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Bibliographic Info

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
Date of revision:
Handle: RePEc:bos:wpaper:wp2006-017

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  1. 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.
  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.
  3. 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.
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