Feedback and Contagion through Distressed Competition

79 Pages Posted: 5 Feb 2020 Last revised: 20 Apr 2020

See all articles by Hui Chen

Hui Chen

Massachusetts Institute of Technology; National Bureau of Economic Research (NBER)

Winston Dou

The Wharton School, University of Pennsylvania

Hongye Guo

University of Pennsylvania

Yan Ji

Hong Kong University of Science & Technology (HKUST)

Date Written: April 16, 2020

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

Suggested Citation

Chen, Hui and Dou, Winston and Guo, Hongye and Ji, Yan, Feedback and Contagion through Distressed Competition (April 16, 2020). Available at SSRN: https://ssrn.com/abstract=3513296 or http://dx.doi.org/10.2139/ssrn.3513296

Hui Chen

Massachusetts Institute of Technology ( email )

50 Memorial Drive
Cambridge, MA 02142
United States
617-324-3896 (Phone)

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Winston Dou (Contact Author)

The Wharton School, University of Pennsylvania ( email )

2318 Steinberg Hall - Dietrich Hall
3620 Locust Walk
Philadelphia, PA 19104
United States

Hongye Guo

University of Pennsylvania ( email )

Yan Ji

Hong Kong University of Science & Technology (HKUST) ( email )

Clearwater Bay
Kowloon, 999999
Hong Kong

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