Financial Frictions and Risky Corporate Debt
University of Minnesota
Ziff Brothers Investments - Risk Management
January 24, 2007
We offer clarifications on Cooley and Quadrini (2001) regarding financial frictions and risky corporate-debt pricing. Even in a frictionless world, the promised rate on corporate debt is not identical across firms and across capital structures and it is not equal to the risk-free rate. Frictions are unnecessary for credit spreads to arise. Only if the macroeconomy is in actuality risk free or risk neutral do interest rates on corporate debt reflect default probabilities. To the extent that the firm's entire financial structure is traded, a bias in credit spreads introduces an exploitable arbitrage opportunity. Re-establishing no-arbitrage, firm dynamics move in the opposite direction of Cooley and Quadrini's.
Number of Pages in PDF File: 9
Keywords: Corporate Debt, Merton Model, No-Arbitrage Pricing
JEL Classification: E43, E44, G2, G12, G13, G32, G33working papers series
Date posted: March 21, 2006
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