Abstract

http://ssrn.com/abstract=310900
 
 

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When Does Strategic Debt-Service Matter?


Rangarajan K. Sundaram


New York University (NYU) - Department of Finance

Viral V. Acharya


New York University - Leonard N. Stern School of Business; Centre for International Finance and Regulation (CIFR); Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER); New York University (NYU) - Department of Finance

Jing-Zhi Huang


Pennsylvania State University - University Park - Department of Finance

Marti G. Subrahmanyam


New York University - Stern School of Business

May 2, 2002


Abstract:     
Recent work has suggested that strategic underperformance of debt-service obligations by equity holders can resolve the gap between observed yield spreads and those generated by Merton (1974)-style models. We show that this is not quite correct. The value of the option to underperform on debt-service obligations depends on two other optionalities available to equity holders, namely, the option to carry cash reserves within the firm and the option to raise new external financing.

We disentangle the effects of the three factors, and characterize the impact of each in isolation as well as their interaction. We find, among other things, that while strategic behavior can increase spreads significantly under some conditions, its impact is negligible in others, and in some cases it even leads to a decline in equilibrium spreads. We show that this last apparently paradoxical result is a consequence of an interaction of optionalities that results in a trade-off between strategic and liquidity-driven defaults.

Number of Pages in PDF File: 45

Keywords: strategic debt-service, interaction of optionalities, liquidity default, strategic default, cash-management

JEL Classification: G30, G33, G35

working papers series


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Date posted: May 27, 2002  

Suggested Citation

Sundaram, Rangarajan K. and Acharya, Viral V. and Huang, Jing-Zhi and Subrahmanyam, Marti G., When Does Strategic Debt-Service Matter? (May 2, 2002). Available at SSRN: http://ssrn.com/abstract=310900 or http://dx.doi.org/10.2139/ssrn.310900

Contact Information

Rangarajan K. Sundaram (Contact Author)
New York University (NYU) - Department of Finance ( email )
Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States
212-998-0308 (Phone)
212-995-4233 (Fax)
Viral V. Acharya
New York University - Leonard N. Stern School of Business ( email )
44 West 4th Street
New York, NY NY 10012
United States
HOME PAGE: http://pages.stern.nyu.edu/~sternfin/vacharya/public_html/~vacharya.htm
Centre for International Finance and Regulation (CIFR) ( email )
Level 7, UNSW CBD Campus
1 O'Connell Street
Sydney, NSW 2000
Australia

Centre for Economic Policy Research (CEPR)
77 Bastwick Street
London, EC1V 3PZ
United Kingdom
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
New York University (NYU) - Department of Finance
Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States
Jing-Zhi Jay Huang
Pennsylvania State University - University Park - Department of Finance ( email )
University Park, PA 16802
United States
HOME PAGE: http://www.personal.psu.edu/jxh56
Marti G. Subrahmanyam
New York University - Stern School of Business ( email )
Stern School of Business,
44 West 4th Street, Suite 9-68
New York, NY 10012-1126
United States
212-998-0348 (Phone)
212-995-4233 (Fax)
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