Interest Rates and the Design of Financial Contracts
61 Pages Posted: 13 Jan 2020 Last revised: 12 Aug 2021
Date Written: May 9, 2020
We show that variation in short-term nominal interest rates produces an endogenous response in the design of and commitment to corporate loan contracts. Interest rates are inversely related to the cash flow rights and positively related to the control rights granted to creditors. An implication of this contractual response is a sharp increase in the ex post renegotiation of contracts originated in low interest rate environments, as well as a muted effect of interest rate variation on the cost of debt capital. Our findings illustrate how the design of financial contracts in practice reflects a multi-dimensional tradeoff among contract features that aligns incentives and apportions risk among the contracting parties in a state-contingent manner.
Keywords: financial contracts, interest rates, banking, commercial lending
JEL Classification: G21, G23, E43, E52
Suggested Citation: Suggested Citation