When Does Strategic Debt Service Matter?

45 Pages Posted: 5 Nov 2008

See all articles by Viral V. Acharya

Viral V. Acharya

New York University - Leonard N. Stern School of Business; 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 (NYU) - Department of Finance

Rangarajan K. Sundaram

New York University (NYU) - Department of Finance

Multiple version iconThere are 5 versions of this paper

Date Written: May 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.

Suggested Citation

Acharya, Viral V. and Huang, Jing-Zhi Jay and Subrahmanyam, Marti G. and Sundaram, Rangarajan K., When Does Strategic Debt Service Matter? (May 2002). NYU Working Paper No. S-CDM-02-03. Available at SSRN: https://ssrn.com/abstract=1295818

Viral V. Acharya (Contact Author)

New York University - Leonard N. Stern School of Business ( email )

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HOME PAGE: http://pages.stern.nyu.edu/~sternfin/vacharya/public_html/~vacharya.htm

Centre for Economic Policy Research (CEPR)

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United Kingdom

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
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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 (NYU) - Department of Finance ( 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)

Rangarajan K. Sundaram

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)

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