Price Rigidities and Credit Risk
79 Pages Posted: 25 May 2021 Last revised: 21 Aug 2021
Date Written: August 20, 2021
We develop a capital structure model in which firms feature differential flexibility in adjusting output prices to shocks. Inflexible-price firms have lower profits and higher cash-flow volatility, leading in equilibrium to lower financial leverage, shorter debt duration, higher cost of debt, more stringent debt covenants, and higher precautionary cash holdings. Moreover, a cash-flow volatility shock increases the cost of debt more for inflexible-price firms. We confirm these predictions empirically and exploit the 2008 Lehman Brothers bankruptcy to show that inflexible-price firms with higher pre-shock rollover risk exposure experience a significantly larger increase in credit spreads following the event than other firms.
Keywords: sticky prices, monetary policy, credit risk, nominal rigidities
JEL Classification: E12, E44, E52, G12, G28, G32, G33
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