FIN-03-047 |
NYU Stern School of Business |
November 2003
Suleyman Basak and Alex Shapiro
ABSTRACT
This paper studies the optimal policies of borrowers (firms or
individuals) who may default subject to default costs, and analyzes
the asset pricing implications. Borrowers defaulting under adverse
economic conditions may, despite incurring default costs, emerge as
wealthier than non-borrowers or those who can default costlessly.
Under many economic scenarios, borrowers takes on less risk exposure
than non-borrowers, and asset substitution is not pronounced. However,
a larger risk exposure by borrowers may occur as well, depending on
the structure of default costs and on how debt maturity relates to the
planning horizon. In the latter case, borrowers’ default policies
render binary options to be useful credit derivatives for lenders in
hedging the credit-risk component of their assets. In our model, the
asset-value dynamics are endogenously determined, and are shown to
exhibit stochastic mean return and volatility in contrast to the
exogenously assumed constant mean and volatility in many credit risk
models. We consider a variety of extensions, including equilibrium,
where a lower (higher) risk exposure by borrowers manifests itself in
an attenuated (amplified) market volatility and risk premium, but the
market value is always higher in economic downturns, and lower in
upturns, compared to an economy without the presence of credit risk.
Suleyman Basak
Institution: London Business School, Regent’s Park, London - NW1 4SA, UK
Phone: +44 (0) 20-7706-6847
Fax: +44 (0) 20-7724-3317
Email: sbasak@london.edu
Alex Shapiro
Institution: Stern School of Business, New York University
Phone: (212) 998-0362
Fax: (212) 995-4233
Email: ashapiro@stern.nyu.edu
Home Page: http://www.stern.nyu.edu/~ashapiro
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