When Does Strategic Debt-Service Matter?
Rangarajan K. Sundaram
New York University (NYU) - Department of Finance
Viral V. Acharya
New York University - Leonard N. Stern School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER); New York University (NYU) - Department of Finance
Pennsylvania State University - University Park - Department of Finance
Marti G. Subrahmanyam
New York University - Stern School of Business
May 2, 2002
Recent work has suggested that strategic underperformance of debt-service obligations by equity holders can resolve the gap between observed yield spreads and those generated by Merton (1974)-style models. We show that this is not quite correct. The value of the option to underperform on debt-service obligations depends on two other optionalities available to equity holders, namely, the option to carry cash reserves within the firm and the option to raise new external financing.
We disentangle the effects of the three factors, and characterize the impact of each in isolation as well as their interaction. We find, among other things, that while strategic behavior can increase spreads significantly under some conditions, its impact is negligible in others, and in some cases it even leads to a decline in equilibrium spreads. We show that this last apparently paradoxical result is a consequence of an interaction of optionalities that results in a trade-off between strategic and liquidity-driven defaults.
Number of Pages in PDF File: 45
Keywords: strategic debt-service, interaction of optionalities, liquidity default, strategic default, cash-management
JEL Classification: G30, G33, G35
Date posted: May 27, 2002