Risk and the Role of Collateral in Debt Renegotiation
12 Pages Posted: 11 Oct 2013
Date Written: November 2013
In his basic model of debt renegotiation, Bester () argues that collateral is more effective if high‐risk projects are financed. This result, however, depends crucially on the definition of risk. Using the second‐order stochastic dominance criterion, introduced by Rothschild and Stiglitz (), we show that a project's high risk, induced by a high probability of default, does not improve the effectiveness of collateral. Instead it turns out that, given the expected return, the probability of default has no impact on the collateral's effectiveness. Moreover, a higher risk of the project caused by a higher loss given default makes the use of collateral even less effective.
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