The Technical Default Spread

76 Pages Posted: 18 Nov 2021

See all articles by Emilio Bisetti

Emilio Bisetti

Hong Kong University of Science and Technology (HKUST)

Kai Li

Peking University HSBC Business School

Jun YU

Hong Kong University of Science and Technology

Date Written: November 3, 2021

Abstract

We study the quantitative impact of lender control rights on firm investment, asset prices, and the aggregate economy. We build a general equilibrium model with endogenous loan covenants, in which the breaching of a covenant (technical default) entails a switch in investment control rights from borrowers to lenders. Lenders optimally choose low-risk projects, thus mitigating borrowers' risk-taking incentives and reducing a firm's cost of equity. Such a mechanism mitigates the financial accelerator effect (Bernanke et. al. 1999), and generates a technical default spread that firms closer to technical default earn 4% lower average returns than those further away from it.

Keywords: loan covenants, technical default, creditor control rights, cross section of stock returns

JEL Classification: E2, E3, G12

Suggested Citation

Bisetti, Emilio and Li, Kai and YU, Jun, The Technical Default Spread (November 3, 2021). Available at SSRN: https://ssrn.com/abstract=3957036 or http://dx.doi.org/10.2139/ssrn.3957036

Emilio Bisetti

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

Clear Water Bay, Kowloon
Hong Kong

Kai Li (Contact Author)

Peking University HSBC Business School ( email )

+86 755 26032023 (Phone)

HOME PAGE: http://sites.google.com/site/kailiwebpage

Jun YU

Hong Kong University of Science and Technology ( email )

Hong Kong

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