Feedback and Contagion through Distressed Competition

Abstract

Firms tend to compete more aggressively when they are in financial distress; the intensified competition reduces the profit margins for all firms in the industry, pushing everyone further into distress. To study such feedback and contagion effects, we incorporate a supergame of strategic competition into a dynamic model of long-term defaultable debt. Depending on the relative market share and financial strength as well as entry threats, firms in the model exhibit a rich variety of strategic interactions, including predation, self-defense, and collaboration. A key result of our model is that, due to financial contagion, the credit risks of leading firms in an industry are jointly determined, whereby firm-specific shocks can significantly affect the credit risk of peer firms. In addition, the competition-distress feedback affects firms' aggregate risk exposure, which helps explain the puzzling joint cross-sectional patterns of equity and bond returns. Finally, we also provide empirical support for our model's predictions. In particular, we exploit exogenous variations in market structure -- large tariff cuts -- to test the endogenous competition mechanism directly.

Keywords: Stock and Bond Returns, Predatory Price Wars, Tacit Collusion, Financial Distress

JEL Classification: G12, L13, O33, C73