Debt Covenants and the Expected Cost of Technical Default

48 Pages Posted: 15 Jun 2016

See all articles by Aytekin Ertan

Aytekin Ertan

London Business School

Stephen A. Karolyi

Office of the Comptroller of the Currency

Date Written: June 13, 2016

Abstract

To estimate the expected cost of technical default for equityholders, we analyze the stock market reaction to changes in the ex-ante likelihood of technical default. Our large-sample, ex-ante estimates exceed five percent of equity value, which reflects material monetary and risk consequences of lender control. Small-sample, ex-post estimates using market reactions to default announcements are smaller, consistent with anticipation and selection. In cross-sectional tests, we find that equityholders anticipate technical defaults and that renegotiating borrowers' ex-ante expected technical default costs exceed that of defaulters. Moreover, we show that creditor coordination and monitoring problems increase the expected cost of default.

Keywords: debt covenants, technical default, control rights, shareholder-debtholder conflict

JEL Classification: G14, G32, G33, M41

Suggested Citation

Ertan, Aytekin and Karolyi, Stephen A., Debt Covenants and the Expected Cost of Technical Default (June 13, 2016). Available at SSRN: https://ssrn.com/abstract=2795226 or http://dx.doi.org/10.2139/ssrn.2795226

Aytekin Ertan

London Business School ( email )

Sussex Place
Regent's Park
London, NW1 4SA
United Kingdom
442070008131 (Phone)

Stephen A. Karolyi (Contact Author)

Office of the Comptroller of the Currency ( email )

400 7th Street SW
Washington, DC 20219
United States

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