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A Collateral Theory of Endogenous Debt Maturity

Listed author(s):
  • R. Matthew Darst
  • Ehraz Refayet

This paper studies optimal debt maturity when firms must use collateral to back non-contingent claims. The optimal term structure of debt trades-off long-term borrowing costs and short-term refinancing costs because the price of risk is different across states and through time. Issuing both long- and short-term debt allows firms to cater risky promises across time to investors most willing to hold risk. Collateral frictions produce a rich term structure of debt that includes safe "money-like" debt, risky short- and long-term debt, and contrast existing theories predicated on information frictions or liquidity risk. Lastly, we show that "hard" secured debt covenants in long-term debt do not affect investment or credit spreads when collateral is scarce because they act as perfect substitutes for short-term debt.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2017-057.

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Length: 41 pages
Date of creation: May 2017
Handle: RePEc:fip:fedgfe:2017-57
DOI: 10.17016/FEDS.2017.057
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