When does Strategic Debt-service Matter?
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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Volume (Year): 29 (2006)
Issue (Month): 2 (October)
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- Mella-Barral, Pierre & Perraudin, William, 1997.
" Strategic Debt Service,"
Journal of Finance,
American Finance Association, vol. 52(2), pages 531-56, June.
- Oliver Hart & John Moore, 1997.
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STICERD - Theoretical Economics Paper Series
321, Suntory and Toyota International Centres for Economics and Related Disciplines, LSE.
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- Hart, O. & Moore, J., 1989. "Default And Renegotiation: A Dynamic Model Of Debt," Working papers 520, Massachusetts Institute of Technology (MIT), Department of Economics.
- Oliver Hart & John Moore, 1997. "Default and Renegotiation: A Dynamic Model of Debt," Harvard Institute of Economic Research Working Papers 1792, Harvard - Institute of Economic Research.
- Viral Acharya & Jing-zhi Huang & Marti Subrahmanyam & Rangarajan Sundaram, 2006.
"When does Strategic Debt-service Matter?,"
Springer;Society for the Advancement of Economic Theory (SAET), vol. 29(2), pages 363-378, October.
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