FIN-02-013

When Does Strategic Debt Service Matter?

May 2002

Viral V. Acharya, Jing-zhi Huang, Marti G. Subrahmanyam and 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 (1974)-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.
Classification: G13, G35, G33

Viral V. Acharya
Institution: Institute of Finance and Accounting, London Business School, 6 Sussex Place, Regent's Park London, NW1 4SA England
Telephone: 44-20-7262 5050 x. 3535
Fax: 44-20-7724 3317
Email: vacharya@london.edu
Homepage:http://www.stern.nyu.edu/~vacharya

Jing-zhi Huang
Institution: Smeal School of Business, Penn State University, University Park, PA 16802
Email: jxh56@psu.edu

Marti G. Subrahmanyam
Institution: Stern School of Business, New York University, 44th West 4th Street, New York, NY 10012
Telephone: (212) 998-0348
Fax: (212) 995-4233
Email: msubrahm@stern.nyu.edu
Homepage: http://www.stern.nyu.edu/~msubrahm

Rangarajan K. Sundaram
Institution: Stern School of Business, New York University, 44th West 4th Street, New York, NY 10012
Telephone: (212) 998-0308
Fax: (212) 995-4233
Email: rsundara@stern.nyu.edu
Homepage:http://www.stern.nyu.edu/~rsundara

To download a copy of this paper click here
To request a copy of this paper click here

The Department of Finance Working Paper Series has been generously sponsored by