Risk and the Role of Collateral in Debt Renegotiation
10 Pages Posted: 31 Jan 2010 Last revised: 10 Dec 2011
Date Written: July 26, 2011
In his basic model of debt renegotiation, Bester (1994) argues that collateral is more effective if high risk projects are financed. This result, however, cru-cially depends on the definition of risk. Using the second-order stochastic dominance criterion introduced by Rothschild and Stiglitz (1970), we show that it is not a project’s high risk, induced by a high probability of default, that makes collateral more effective. Instead it turns out that, given the expected return, the probability of default has no impact on the collateral’s effective-ness. Moreover, an increasing risk of the project caused by an increasing loss given default makes the use of collateral even less effective.
Keywords: Debt renegotiation, Collateral, Risk, Stochastic dominance
JEL Classification: D81, D82, G21, G32
Suggested Citation: Suggested Citation