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When Does Strategic Debt Service Matter?

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Author Info
Acharya, Viral V
Huang, Jing-Zhi
Subrahmanyam, Marti G.
Sundaram, Rangarajan K

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Abstract

Recent work has suggested that strategic underperformance of debt-service obligations by equity holders can resolve the gap between observed yield spreads and those generated by Merton-style models. We show that this is not quite correct. The value of the option to underperform on debt-service obligations depends on two other optionalities available to equity holders, namely, the option to carry cash reserves within the firm and the option to raise new external financing. We disentangle the effects of the three factors, and characterize the impact of each in isolation as well as their interaction. We find, among other things, that while strategic behavior can increase spreads significantly under some conditions, its impact is negligible in others, and in some cases it even leads to a decline in equilibrium spreads. We show that this last apparently paradoxical result is a consequence of an interaction of optionalities that results in a trade-off between strategic and liquidity-driven defaults.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 3566.

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Date of creation: Oct 2002
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Handle: RePEc:cpr:ceprdp:3566

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Related research
Keywords: cash-management; interaction of optionalities; liquidity default; strategic debt-service; strategic default;

Other versions of this item:

Find related papers by JEL classification:
G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
G35 - Financial Economics - - Corporate Finance and Governance - - - Payout Policy

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Hart, O. & Moore, J., 1989. "Default And Renegotiation: A Dynamic Model Of Debt," Working papers 520, Massachusetts Institute of Technology (MIT), Department of Economics.
    Other versions:
  2. Acharya, Viral V & Huang, Jing-Zhi & Subrahmanyam, Marti G. & Sundaram, Rangarajan K, 2002. "When Does Strategic Debt Service Matter?," CEPR Discussion Papers 3566, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
    Other versions:
  3. Mella-Barral, Pierre & Perraudin, William, 1997. " Strategic Debt Service," Journal of Finance, American Finance Association, vol. 52(2), pages 531-56, June. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Viral Acharya & Jing-zhi Huang & Marti Subrahmanyam & Rangarajan Sundaram, 2006. "When does Strategic Debt-service Matter?," Economic Theory, Springer, vol. 29(2), pages 363-378, October. [Downloadable!] (restricted)
    Other versions:
  2. Anderson, Ronald W & Carverhill, Andrew, 2005. "A Model of Corporate Liquidity," CEPR Discussion Papers 4994, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
  3. Biais, Bruno & Mariotti, Thomas & Plantin, Guillaume & Rochet, Jean-Charles, 2004. "Dynamic Security Design: Convergence to Continuous Time and Asset Pricing Implications," IDEI Working Papers 312, Institut d'Économie Industrielle (IDEI), Toulouse, revised Sep 2006. [Downloadable!]
    Other versions:
  4. Anderson, Ronald W & Carverhill, Andrew, 2007. "Liquidity and Capital Structure," CEPR Discussion Papers 6044, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
  5. Heitor Almeida & Murillo Campello & Michael S. Weisbach, 2002. "Corporate Demand for Liquidity," NBER Working Papers 9253, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  6. Ilya A. Strebulaev, 2004. "Do Tests of Capital Structure Theory Mean What They Say?," Econometric Society 2004 North American Summer Meetings 646, Econometric Society. [Downloadable!]
  7. Alon Raviv, 2004. "Bank Stability and Market Discipline: Debt-for-Equity Swap versus Subordinated Notes," Finance 0408003, EconWPA. [Downloadable!]
  8. R. Jarrow & A. Purnanandam, 2007. "The valuation of a firm’s investment opportunities: a reduced form credit risk perspective," Review of Derivatives Research, Springer, vol. 10(1), pages 39-58, January. [Downloadable!] (restricted)
  9. Linda Allen & Anthony Saunders, 2004. "Incorporating Systemic Influences Into Risk Measurements: A Survey of the Literature," Journal of Financial Services Research, Springer, vol. 26(2), pages 161-191, October. [Downloadable!] (restricted)
  10. Acharya, Viral V. & Davydenko, Sergei A. & Strebulaev, Ilya, 2009. "Cash Holdings and Credit Risk," CEPR Discussion Papers 7125, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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