Risk and the Role of Collateral in Debt Renegotiation

10 Pages Posted: 31 Jan 2010 Last revised: 10 Dec 2011

See all articles by Werner Neus

Werner Neus

Universitaet Tuebingen - Department of Banking

Manfred Stadler

University of Tuebingen

Multiple version iconThere are 2 versions of this paper

Date Written: July 26, 2011

Abstract

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

Neus, Werner and Stadler, Manfred, Risk and the Role of Collateral in Debt Renegotiation (July 26, 2011). Available at SSRN: https://ssrn.com/abstract=1544248 or http://dx.doi.org/10.2139/ssrn.1544248

Werner Neus (Contact Author)

Universitaet Tuebingen - Department of Banking ( email )

Mohlstrasse 36
D-72074 Tuebingen, 72074
Germany

Manfred Stadler

University of Tuebingen ( email )

Mohlstrasse 36
D-72074 Tuebingen, 72074
Germany

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