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A Continuous-Time Analysis of Optimal Defaultable Debt Contracts: Theory and Applications

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  • Hisashi Nakamura

    (Faculty of Economics, University of Tokyo)

Abstract

This paper presents a new approach for modeling continuous-time defaultable debt contracts. It studies an optimal competitive debt contract in continuous time by exploring a dynamic costly monitoring model under asymmetric information in a common-agency setting. It shows that, under an optimal debt contract, a fully informed debtor defaults strategically and recurrently. On the other hand, a less informed creditor expects default to occur stochastically based on an exponential probability distribution under which the arrival rate of default is increasing in monitoring ability. This paper provides a mathematically tractable framework to analyze firms' financial structure and dynamic auditing problems in labor and insurance contracts.

Suggested Citation

  • Hisashi Nakamura, 2006. "A Continuous-Time Analysis of Optimal Defaultable Debt Contracts: Theory and Applications," CARF F-Series CARF-F-068, Center for Advanced Research in Finance, Faculty of Economics, The University of Tokyo.
    • Handle: RePEc:cfi:fseres:cf068
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    Cited by:

    1. Cheng Wang, 2005. "Dynamic costly state verification," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 25(4), pages 887-916, June.

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