Financial Covenants, Credit Risk, and the Resolution of Uncertainty

44 Pages Posted: 26 Feb 2010  

Peter R. Demerjian

University of Washington - Michael G. Foster School of Business

Date Written: February 25, 2010

Abstract

I examine the role of financial covenants in private debt contracts. I predict that financial covenants help limit ex ante uncertainty about the borrower’s performance - the risk that the borrower will default on the loan - in the contract. I find that covenant inclusion is positively related to uncertainty measured prior to contracting. I also find that the selection of the covenant measure is associated with the leverage and earnings performance of the borrower. This is consistent with covenants featuring the financial measure most informative of borrower debt value and default risk. The results suggest that financial covenants limit the risk of making loans to borrowers with uncertain future performance.

Keywords: Debt Contracting, Covenants, Uncertainty, Default Risk

JEL Classification: M40, G32

Suggested Citation

Demerjian, Peter R., Financial Covenants, Credit Risk, and the Resolution of Uncertainty (February 25, 2010). Available at SSRN: https://ssrn.com/abstract=1559232 or http://dx.doi.org/10.2139/ssrn.1559232

Peter R. Demerjian (Contact Author)

University of Washington - Michael G. Foster School of Business ( email )

Box 353200
Seattle, WA 98195-3200
United States

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