How Good are Standard Debt Contracts? Stochastic Versus Nonstochastic Monitoring in a Costly State Verification Environment

JOURNAL OF BUSINESS, Vol 67 No 4, October 1994

Posted: 20 Dec 1998

See all articles by John H. Boyd

John H. Boyd

University of Minnesota - Twin Cities - Carlson School of Management

Bruce D. Smith

University of Texas at Austin (Deceased)

Abstract

We investigate ex ante efficient contracts in an environment in which implementation is costless. In this environment, standard debt contracts will typically not be optimal. Optimal contracts may involve defaults, even in states in which the borrower is fully able to repay. We then examine the welfare costs of arbitrarily restricting the set of feasible contracts to standard debt contracts. When model parameters are calibrated to realistic values, the welfare loss from exogenously imposing this restriction is extremely small. Thus, if implementation costs are actually nontrivial (as seem likely), standard debt contracts will be (very close to) optimal.

JEL Classification: G2

Suggested Citation

Boyd, John H. and Smith, Bruce D., How Good are Standard Debt Contracts? Stochastic Versus Nonstochastic Monitoring in a Costly State Verification Environment. JOURNAL OF BUSINESS, Vol 67 No 4, October 1994, Available at SSRN: https://ssrn.com/abstract=5594

John H. Boyd (Contact Author)

University of Minnesota - Twin Cities - Carlson School of Management ( email )

19th Avenue South
Minneapolis, MN 55455
United States
612-624-1834 (Phone)

Bruce D. Smith

University of Texas at Austin (Deceased)

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