Heterogeneous Beliefs, Collateral, and Endogenous Debt Maturity

47 Pages Posted: 14 Feb 2016 Last revised: 26 Jan 2018

See all articles by Matthew Darst

Matthew Darst

Board of Governors of the Federal Reserve System

Ehraz Refayet

Office of the Comptroller of the Currency, Department of Treasury

Multiple version iconThere are 2 versions of this paper

Date Written: October 23, 2017

Abstract

This paper studies optimal debt maturity when firms must use collateral to back non-contingent claims and investors disagree about repayment probabilities. Long-term debt insulates the firm from changes in the price of credit risk but is costly when collateral is insufficient to ensure full repayment. Shortterm debt may be risk free conditional on good states, but exposes the firm to credit spread spikes in bad states. The optimal debt maturity choice to finance investment combines long- and short-term debt. Issuing multiple debt maturities allows firms to cater risky promises across time to investors most willing to hold risk. Collateral frictions and heterogeneous investors directly contrasts theories of debt predicated on agency costs, information frictions, or liquidity risk. Lastly, we show that covenants that prevent dilution may not affect real outcomes when collateral is scarce because they do not allow the firm to create new collateral. They simply reallocate collateral from short-term to long-term debt holders.

Keywords: Collateral, Debt Maturity, Investment, Cost of Capital, Debt Covenants, Seniority

JEL Classification: D92, G11, G12, G31, G32, E22

Suggested Citation

Darst, Matthew and Refayet, Ehraz, Heterogeneous Beliefs, Collateral, and Endogenous Debt Maturity (October 23, 2017). Available at SSRN: https://ssrn.com/abstract=2731751 or http://dx.doi.org/10.2139/ssrn.2731751

Matthew Darst (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Ehraz Refayet

Office of the Comptroller of the Currency, Department of Treasury ( email )

400 7th Street SW
Washington, DC 20219
United States

HOME PAGE: http://www.occ.treas.gov/topics/economics/economics-staff/bios/ehraz-refayet-bio.html

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