Unemployment Risk and Debt Contract Design

54 Pages Posted: 5 Dec 2018

See all articles by Chris Armstrong

Chris Armstrong

Stanford Graduate School of Business

Daniel A. Cohen

Vanderbilt University - Owen Graduate School of Management

Nir Yehuda

University of Delaware - Accounting & MIS

Xiaolu Zhou

University of Texas at Dallas

Date Written: November 17, 2018

Abstract

We examine how firms’ contractual relationships with their employees affect the design of their debt contracts, and their use of financial covenants and pricing grids in particular. Viewing the firm as nexus of both explicit and implicit contractual relationships, we argue that managers internalize their employees’ preferences when negotiating contractual terms with creditors. An increase in unemployment insurance benefits reduces employees’ cost of job loss which, in turn, allows managers to take more risk. We find that loans initiated following an increase in unemployment insurance benefits are more likely to include performance rather than capital covenants and are more likely to include pricing grids based on financial (i.e., profitability) ratios rather than credit ratings. Overall, our study demonstrates how the design of debt contracts changes in response to arguably exogenous changes in employees’ collective tolerance — and, in turn, managers’ preferences — for risk.

Keywords: Unemployment, Debt Contract Design

JEL Classification: M41, G32, J60

Suggested Citation

Armstrong, Chris S. and Cohen, Daniel A. and Yehuda, Nir and Zhou, Xiaolu, Unemployment Risk and Debt Contract Design (November 17, 2018). Available at SSRN: https://ssrn.com/abstract=3293221 or http://dx.doi.org/10.2139/ssrn.3293221

Chris S. Armstrong

Stanford Graduate School of Business ( email )

655 Knight Way
E316
Stanford, CA 94305-5015
United States

HOME PAGE: http://https://www.gsb.stanford.edu/faculty-research/faculty/christopher-s-armstrong

Daniel A. Cohen

Vanderbilt University - Owen Graduate School of Management ( email )

401 21st Avenue South
Nashville, TN 37203
United States

Nir Yehuda (Contact Author)

University of Delaware - Accounting & MIS ( email )

Alfred Lerner College of Business and Economics
Newark, DE 19716
United States

HOME PAGE: http://https://lerner.udel.edu/faculty-staff-directory/nir-yehuda/

Xiaolu Zhou

University of Texas at Dallas ( email )

2601 North Floyd Road
Richardson, TX 75083
United States

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