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Endogenous Debt Maturity: Liquidity Risk vs. Default Risk

Author

Listed:
  • Juan Sanchez

    (Federal Reserve Bank of St. Louis)

  • Rodolfo Manuelli

    (Washington University and Federal Reserve Bank of St. Louis)

Abstract

We study the joint determination of a technology ---the degree of illiquidity of a project, its mean growth rate and the variability of the growth rate--- — and the optimal debt …financing ---the face value of the debt, its coupon rate, and expected maturity—--- in an economy in which credit markets and decision makers are risk neutral and have the same discount rate. Our results show that the optimal maturity of the debt balances the risk of default due to illiquidity with the risk of strategic default. In a quantitative exercise we show how the optimal structure of debt varies with technological and environmental parameters. We …find that when output is low (and, hence, the probability of default is high) …firms choose to issue short term debt. In general, there is a positive relationship between output and maturity. We also fi…nd … that firms operating in more uncertain environments choose to issue shorter debt, while fi…rms whose assets have higher resale value (e.g. face lower costs of …re sales) issue longer maturity debt.

Suggested Citation

  • Juan Sanchez & Rodolfo Manuelli, 2016. "Endogenous Debt Maturity: Liquidity Risk vs. Default Risk," 2016 Meeting Papers 1435, Society for Economic Dynamics.
  • Handle: RePEc:red:sed016:1435
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    References listed on IDEAS

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    Cited by:

    1. Julian Kozlowski, 2017. "Long-Term Finance and Economic Development: The Role of Liquidity in Corporate Debt Markets," 2017 Meeting Papers 699, Society for Economic Dynamics.

    More about this item

    JEL classification:

    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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