Feedback and Contagion through Distressed Competition

Firms tend to compete more aggressively in financial distress; the intensified competition in turn reduces profit margins, pushing themselves further into distress and adversely affecting other firms. To study such feedback and contagion effects, we incorporate strategic competition into a dynamic model with long-term defaultable debt, which generates various peer interactions like predation and self-defense. The feedback effect imposes an additional source of financial distress costs incurred for raising leverage, which helps explain the negative profitability-leverage relation across industries. Owing to the contagion effect, in a decentralized equilibrium, leverage is excessively high from an industry perspective, compromising industry's financial stability.

Keywords: Competition-distress feedback loop, Distress spillover, Predatory price war, Profitability-leverage puzzle, Tacit collusion

JEL Classification: C73, D43, E31, G3, L13, O33

Suggested Citation: Suggested Citation

Chen, Hui and Dou, Winston Wei and Guo, Hongye and Ji, Yan, Feedback and Contagion through Distressed Competition (December 31, 2022). The Rodney L. White Center Working Papers Series at the Wharton School, Jacobs Levy Equity Management Center for Quantitative Financial Research Paper, Available at SSRN: https://ssrn.com/abstract=3513296 or http://dx.doi.org/10.2139/ssrn.3513296