Feedback and Contagion Through Distressed Competition

62 Pages Posted: 16 Jan 2023 Last revised: 14 Apr 2023

See all articles by Hui Chen

Hui Chen

Massachusetts Institute of Technology

Winston Wei Dou

The Wharton School, University of Pennsylvania; National Bureau of Economic Research (NBER)

Hongye Guo

University of Pennsylvania

Yan Ji

Hong Kong University of Science & Technology (HKUST)

Multiple version iconThere are 2 versions of this paper

Date Written: January 2023

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.

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Suggested Citation

Chen, Hui and Dou, Winston Wei and Guo, Hongye and Ji, Yan, Feedback and Contagion Through Distressed Competition (January 2023). NBER Working Paper No. w30841, Available at SSRN: https://ssrn.com/abstract=4325034 or http://dx.doi.org/10.2139/ssrn.4325034

Hui Chen (Contact Author)

Massachusetts Institute of Technology ( email )

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Winston Wei Dou

The Wharton School, University of Pennsylvania ( email )

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HOME PAGE: http://www.nber.org/people/winston_wei_dou?page=1&perPage=50

Hongye Guo

University of Pennsylvania ( email )

Yan Ji

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

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