Working Paper: CEPR ID: DP3566
Authors: Viral V. Acharya; Jingzhi Huang; Marti G. Subrahmanyam; Rangarajan K. Sundaram
Abstract: Recent work has suggested that strategic underperformance of debt-service obligations by equity holders can resolve the gap between observed yield spreads and those generated by Merton-style models. We show that this is not quite correct. The value of the option to underperform on debt-service obligations depends on two other optionalities available to equity holders, namely, the option to carry cash reserves within the firm and the option to raise new external financing.We disentangle the effects of the three factors, and characterize the impact of each in isolation as well as their interaction. We find, among other things, that while strategic behavior can increase spreads significantly under some conditions, its impact is negligible in others, and in some cases it even leads to a decline in equilibrium spreads. We show that this last apparently paradoxical result is a consequence of an interaction of optionalities that results in a trade-off between strategic and liquidity-driven defaults.
Keywords: cash management; interaction of optionalities; liquidity; default; strategic debt service; strategic default
JEL Codes: G13; G33; G35
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| strategic underperformance on debt-service obligations (H63) | yield spreads (G12) |
| option to underperform on debt-service obligations (G32) | yield spreads (G12) |
| option to maintain cash reserves (D14) | yield spreads (G12) |
| option to raise external financing (G32) | yield spreads (G12) |
| strategic defaults (G33) | liquidity-driven defaults (G33) |