Market Imperfections, Investment Optionality and Default Spreads

Abstract

This paper develops a structural model that determines default spreads on risky debt. In contrast to previous research, the value of the debt's collateral is endogenously determined by the borrower's investment choice, as well as by a market demand variable that has permanent as well as temporary components. The model also considers market imperfections that limit the borrower's ability to contract to undertake the value-maximizing investment choice, and which may in addition limit the borrower's ability to raise external capital. The model is calibrated with data on commercial mortgages, and based on our calibration, we present numerical simulations that quantify the extent to which investment flexibility, incentive problems and credit constraints affect default spreads.

Keywords: debt pricing, default spreads, agency cost, market imperfections, contracting environment

JEL Classification: G12,G13,G21,G31,G32,G35