A seminar by Senior Lecturer Jun Yu from University of Melbourne
Title: The Technical Default Spread
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 their cost of equity. Such a mechanism mitigates the financial accelerator effect (Bernanke, Gertler, and Gilchrist, 1999), and generates a technical default spread such that firms closer to technical default earn 4% lower average returns than those further away from it.
This is joint work with Geoffrey Kingston and Pavel V. Shevchenko
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