Rollover Risk and Credit Risk
50 Pages Posted: 18 Jan 2010 Last revised: 22 Jan 2010
Date Written: January 2010
This paper models a firm's rollover risk generated by conflict of interest between debt and equity holders. When the firm faces losses in rolling over its maturing debt, its equity holders are willing to absorb the losses only if the option value of keeping the firm alive justifies the cost of paying off the maturing debt. Our model shows that both deteriorating market liquidity and shorter debt maturity can exacerbate this externality and cause costly firm bankruptcy at higher fundamental thresholds. Our model provides implications on liquidity-spillover effects, the flight-to-quality phenomenon, and optimal debt maturity structures.
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