Dynamic Adverse Selection and Belief Update in Credit Markets

63 Pages Posted: 25 Mar 2020 Last revised: 30 Sep 2020

See all articles by Inkee Jang

Inkee Jang

Xiamen University

Kee-Youn Kang

Yonsei University

Date Written: February 28, 2020


We develop a dynamic model of debt contracts with adverse selection and belief updates. In the model, entrepreneurs borrow investment goods from lenders to run businesses whose returns depend on entrepreneurial productivity and common productivity. Entrepreneurial productivity is the entrepreneur's private information, and the lender constructs beliefs about the entrepreneur's productivity based on the entrepreneur's business operation history, common productivity history, and terms of the contract. The model provides insights into the dynamic and cross-sectional relations between firm age and credit risk, persistency of the effects of a temporary productivity shock, cyclical asymmetry of the business cycle, slow recovery after a crisis, and constructive and destructive economic downturns.

Keywords: Adverse selection, Bayesian learning, Debt contracts, Belief update

JEL Classification: C78, D82, D86, E44, G23

Suggested Citation

Jang, Inkee and Kang, Kee-Youn, Dynamic Adverse Selection and Belief Update in Credit Markets (February 28, 2020). Available at SSRN: https://ssrn.com/abstract=3545809 or http://dx.doi.org/10.2139/ssrn.3545809

Inkee Jang

Xiamen University ( email )

Xiamen University Economics
Xiamen, Fujian 361005
+86-13779967150 (Phone)

Kee-Youn Kang (Contact Author)

Yonsei University ( email )

50 Yonsei-ro, Seodaemun-gu
Seoul, 120-749
Korea, Republic of (South Korea)

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