A Note on Financial Frictions and Risky Corporate Debt in Relation to Cooley and Quadrini (2001)
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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- Merton, Robert C, 1974.
"On the Pricing of Corporate Debt: The Risk Structure of Interest Rates,"
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