Feedback and Contagion through Distressed Competition
The Rodney L. White Center Working Papers Series at the Wharton School
Jacobs Levy Equity Management Center for Quantitative Financial Research Paper
61 Pages Posted: 5 Feb 2020 Last revised: 10 Jan 2023
There are 2 versions of this paper
Feedback and Contagion through Distressed Competition
Feedback and Contagion Through Distressed Competition
Date Written: December 31, 2022
Abstract
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