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

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  • 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.

Suggested Citation

  • Doriana Ruffino & Jonathan Treussard, 2006. "A Note on Financial Frictions and Risky Corporate Debt in Relation to Cooley and Quadrini (2001)," Boston University - Department of Economics - Working Papers Series WP2006-017, Boston University - Department of Economics.
    • Handle: RePEc:bos:wpaper:wp2006-017
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    References listed on IDEAS

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    1. Robert C. Merton & Zvi Bodie, 2005. "Design Of Financial Systems: Towards A Synthesis Of Function And Structure," World Scientific Book Chapters, in: H Gifford Fong (ed.), The World Of Risk Management, chapter 1, pages 1-27, World Scientific Publishing Co. Pte. Ltd..
    2. 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 449-470, May.
    3. Thomas F. Cooley & Vincenzo Quadrini, 2001. "Financial Markets and Firm Dynamics," American Economic Review, American Economic Association, vol. 91(5), pages 1286-1310, December.
    4. 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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