Financial Covenants, Credit Risk, and the Resolution of Uncertainty
Peter R. Demerjian
University of Washington - Michael G. Foster School of Business
February 25, 2010
I examine the role of financial covenants in private debt contracts. I predict that financial covenants help limit ex ante uncertainty about the borrower’s performance - the risk that the borrower will default on the loan - in the contract. I find that covenant inclusion is positively related to uncertainty measured prior to contracting. I also find that the selection of the covenant measure is associated with the leverage and earnings performance of the borrower. This is consistent with covenants featuring the financial measure most informative of borrower debt value and default risk. The results suggest that financial covenants limit the risk of making loans to borrowers with uncertain future performance.
Number of Pages in PDF File: 44
Keywords: Debt Contracting, Covenants, Uncertainty, Default Risk
JEL Classification: M40, G32
Date posted: February 26, 2010
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