Bankruptcy laws and debt renegotiation

This paper analyzes the effect of the toughness of bankruptcy law on the number of liquidations in a simple model of borrowing and lending with asymmetric information, where the creditor cannot credibly commit to liquidate the firm if the default occurs. In our setting we consider a bankruptcy law to be a one-dimensional variable that influences creditor's expectation value of collateral. We find that there is an interval of the bankruptcy law, where the number of liquidations decreases in the toughness of the bankruptcy law. We also find that if the liquidation costs are high, softer bankruptcy law is preferred.     

Last resort gambles, risky debt and liquidation policy

This paper develops a real option model in which the interaction between debt, liquidation policy and risky investments is studied. We consider a manager who owns the firm and faces the opportunity to invest in risky projects which may boost current profits at the cost of bankruptcy if they turn out to be unsuccessful. These investments are “last resort gambles” in the sense that, if successful, they save the company from insolvency, while, if unsuccessful, they make liquidation unavoidable. It is shown that last resort gambles delay liquidation. We study how the liquidation trigger and the last resort investment decisions are affected by the firm's capital structure.     

Bankruptcy,overlapping directors,and bank loan pricing

Using a sample of loan facilities borrowed by firms that share directors with bankrupt firms, this study investigates whether the overlapping directors are a transmission channel of the bankruptcy contagion effect in the bank loan market and, if so, what the underlying mechanism is. We find that firms are charged higher loan spreads in the period following the bankruptcy filing of a firm with a common director and that overlapping directors are a relevant channel for the bankruptcy contagion effect, in addition to other channels identified in literature. We also find that the negative contagion effect on loan pricing is most likely driven by the overlapping directors' reputation loss due to their involvement in bankruptcy events, and not by competing hypotheses, such as director distraction and director career concern/experience. Further analyses reveal that the adverse contagion impact on loan spreads is more pronounced when overlapping directors have greater influence over corporate policies or when their reputation is more seriously damaged. Meanwhile, the contagion effect is mitigated when interlocked firms have a higher-quality board. These results further support our evidence of the director reputation loss hypothesis. We strengthen the identification strategy to establish causality. In sum, our study identifies common directors as a channel of bankruptcy contagion effects on loan pricing and director reputation loss as an underlying mechanism.     

Accelerated investment effect of risky debt

In this paper we examine a new effect of risky debt on a firm’s investment strategy. We call this effect “accelerated investment”. It stems from a potential loss of investment option in the event of default. The possibility of default reduces the value of the option to wait and provides equity holders with an incentive to speed up investment. As a result, in the absence of wealth expropriation by a levered firm’s debt holders, its shareholders exercise their investment option earlier than the shareholders of an otherwise identical all-equity firm. This result is at odds with the generally accepted intuition that in the absence of potential wealth transfers and taxes the shareholders of a levered firm would follow the same investment policy as that of an unlevered firm. In addition to providing various illustrations of the accelerated investment effect, we relate its magnitude to the presence of competition for investment opportunities.     

Leverage and pricing of debt in LBOs

We show that the structure and pricing of debt in LBOs mostly depend on a single characteristic of the target firm, pre-LBO profitability. We find a positive relationship between pre-LBO profitability and deal leverage that is consistent with a dynamic trade-off theory of capital structure in the presence of adjustment costs. We argue that the wide range of debt tranches used in LBO financing can be folded into two main categories, senior and junior debt, where the pricing of senior and junior debt depends on their relative use and on bankruptcy risk. Our evidence also suggests that senior lenders oversupply cheap credit during hot buyout markets.     

Managerial ability,information quality,and the design and pricing of corporate debt

We examine if managerial ability affects the efficiency of the contracting environment with lenders. We find that higher ability alters the balance of information-sensitive covenants demanded by outside investors, increases the issuance of bonds with longer maturity, and decreases the issuance of senior secured debt. We also document higher ability reduces the risk premium demanded by investors on information-sensitive debt. These results are collectively consistent with the premise that the mitigation of information risk is an important dimension of managerial ability that has a direct bearing on the structure and pricing of corporate debt.     

On the pricing of contingent claims and the Modigliani-Miller theorem

A general formula is derived for the price of a security whose value under specified conditions is a known function of the value of another security. Although the formula can be derived using the arbitrage technique of Black and Scholes, the alternative approach of continuous-time portfolio strategies is used instead. This alternative derivation allows the resolution of some controversies surrounding the Black and Scholes methodology. Specifically, it is demonstrated that the derived pricing formula must be continuous with continuous first derivatives, and that there is not a ‘pre-selection bias’ in the choice of independent variables used in the formula. Finally, the alternative derivation provides a direct proof of the Modigliani-Miller theorem even when there is a positive probability of bankruptcy.     

Belief updating, debt pricing and financial decisions under asymmetric information

This paper studies debt holders’ belief updating, valuation of corporate debt, and equity owners’ financing decisions during financial distress under asymmetric information. This is done within a continuous-time framework, where the relevant state variable is assumed to follow an Arithmetic Brownian motion (ABM). ABM can take negative values and has very realistic feature compared with Geometric Brownian motion (GBM). Using Chapter 11 of U.S. Bankruptcy Code as a costly screening device, we can characterize which firm will choose private workouts (in the form of strategic debt service) and which will choose to file for the Chapter 11 Bankruptcy procedure (in the form of debt-equity swap) when the firm is in financial distress. Using arguments similar to equilibrium refinements, we give a clear picture of how debt holders’ beliefs about the firm’s types are updated according to the state variable and the firm’s default behavior, and describe optimal strategies of both parties under those beliefs. We also provide an approximate solution to the debt pricing problem under asymmetric information.     

Determinants of financial covenants and pricing of debt in private debt contracts: the UK evidence

This paper presents details of financial covenants given by a sample drawn from the largest 200 non-financial quoted firms in the UK in private debt contracts and analyses these data to see whether there are relationships between the nature of the covenants given and firm characteristics. Data were obtained from 72 firms, of which 17 gave no financial covenants. Firm size was found to be the only significant factor influencing whether firms did or did not give covenants as well as the only factor which influenced the margin given on debt. Some types of covenants given were found to be different from those found in previous research. In particular, there is greater use of EBITDA as a base for both interest cover and gearing covenants. This shows the importance of cash flow based lending as opposed to asset based lending for general financing for large firms.     

Nonparametric,conditional pricing of higher order multivariate contingent claims

This paper describes and applies a nonparametric model for pricing multivariate contingent claims. Multivariate contingent claims are contracts whose payoffs depend on the future prices of more than one underlying variable. The pricing however of these kinds of contracts represents a challenge. All known models are adaptations of earlier ones that have been introduced to price plain vanilla calls and puts. They are imposing strong assumptions on the distributional properties of the underlying variables. In contrast, this study adopts a methodology that relaxes such restrictions. Following [Barone-Adesi, G., Bourgoin, F., Giannopoulos, K., 1998. Don’t Look Back, Risk 11 (August), 100–104; Barone-Adesi, G., Engle, R., Mancini, L., 2004. GARCH Options in Incomplete Markets, mimeo, University of Applied Sciences of Southern Switzerland; Long, X., 2004. Semiparametric Multivariate GARCH Model, mimeo, University of California, Riverside], multivariate pathways for a set of underlying variables are constructed before the option payoffs are computed. This enables the covariances, in addition to the means and variances, to be modelled in a dynamic and nonparametric manner. The model is particular suitable for options whose payoffs depend on variables that are characterised by high nonlinearities and extremes and on higher order multivariate options whose underlying variables are more unlikely to conform to a common theoretical distribution.     

The pricing of risky assets on the Belgian stock market

This paper presents the first empirical examination of the relationship between the average return and the risk of a comprehensive sample of 200 securities which traded continuously from 1966 to 1980 on the Brussels Stock Exchange, a relatively thin equity market. Based on our empirical findings, we cannot reject the hypothesis that the pricing of common stocks on the Brussels Stock Exchange conforms to the Capital Asset Pricing Model.     

Empirical evaluation of asset pricing models: Arbitrage and pricing errors in contingent claims

Hansen and Jagannathan (1997) have developed two measures of pricing errors for asset-pricing models: the maximum pricing error in all static portfolios of the test assets and the maximum pricing error in all contingent claims of the assets. In this paper, we develop simulation-based Bayesian inference for these measures. While the literature reports that the time-varying extensions substantially reduce pricing errors of classic models on the standard test assets, our analysis shows that the reduction is much smaller based on the second measure. Those time-varying models have large pricing errors on the contingent claims of the test assets because their stochastic discount factors are often negative and admit arbitrage opportunities.     

Returns of claims on the upside and the viability of U-shaped pricing kernels

When the pricing kernel is U-shaped, then expected returns of claims with payout on the upside are negative for strikes beyond a threshold, determined by the slope of the U-shaped kernel in its increasing region, and have negative partial derivative with respect to strike in the increasing region of the kernel. Using returns of (i) S&P 500 index calls, (ii) calls on major international equity indexes, (iii) digital calls, (iv) upside variance contracts, and (v) a theoretical construct that we denote as kernel call, we find broad support for the implications of U-shaped pricing kernels. A possible theoretical reconciliation of our empirical findings is explored through a model that accommodates heterogeneity in beliefs about return outcomes and short-selling.     

Arbitrage-free pricing of multi-person game claims in discrete time

We introduce a class of financial contracts involving several parties by extending the notion of a two-person game option to a contract in which an arbitrary number of parties is involved and each of them is allowed to make a wide array of decisions at any time, not restricted to simply exercising the option. The collection of decisions by all parties then determines the contract’s termination date as well as the terminal payoff for each party. We provide sufficient conditions under which a discrete-time multi-person game option has a unique arbitrage-free price, which is additive with respect to any partition of the contract. Our results are illustrated by the detailed study of a particular multi-person contract with puttable tranches.     

Pricing the risk of recovery in default with absolute priority rule violation

This paper proposes a simple approach to infer the risk-neutral density of recovery rates implied by the prices of the debt securities of a firm. The proposed approach is independent of modeling default arrival rates and allows for the violation of absolute priority rule. The paper demonstrates that a new statistic, the adjusted relative spread, captures risk-neutral recovery information in debt prices. Interest rates and firm tangible assets are shown to be significant determinants of the price of recovery. An application illustrates the pricing of credit derivatives written on the realized recovery rate.     

The importance of IRS monitoring to debt pricing in private firms

We examine the link between Internal Revenue Service (IRS) monitoring and yield spreads on private firms’ 144A bond issues. After controlling for security-specific and other firm-specific determinants, we provide evidence that debt financing is cheaper when the probability of a face-to-face IRS audit is higher. Consistent with another prediction, we find that IRS oversight has a stronger impact on bond pricing for private firms with high ownership concentration, which suffer worse agency problems between controlling shareholders and outside investors. Collectively, our research implies that IRS monitoring plays a valuable corporate governance role by reducing information asymmetry evident in borrowing costs.     

The incentive to give incentives: On the relative seniority of debt claims and managerial compensation

We show that the relative seniority of debt and managerial compensation has important implications for the design of remuneration contracts. Whereas the traditional literature assumes that debt is senior to remuneration, there are in reality many cases in which remuneration contracts are de facto senior to debt claims in financially distressed firms and in workouts. We theoretically show that risky debt changes the incentive to provide the manager with performance-related incentives (a “contract substitution” effect). In other words, the relative degree of seniority of managers’ claims and creditors’ claims in case a bankruptcy procedure starts is crucial to determine the optimal incentive contract ex-ante. If managerial compensation is more senior than debt, higher leverage leads to lower power incentive schemes (lower bonuses and option grants) and a higher base salary. In contrast, when compensation is junior, we expect more emphasis on pay-for-performance incentives in highly-levered firms.     

Conservative financial reporting, debt covenants, and the agency costs of debt

Considerable research has documented the role of debt covenants and conservative financial accounting in addressing agency conflicts between lenders and borrowers. Beatty, A., Weber, J., and Yu, J. [2008. Conservatism and debt. Journal of Accounting and Economics, forthcoming] document interesting, but mixed, findings on the relation between debt covenants and conservative accounting, and the extent to which the two contracting mechanisms act as substitutes or complements. In this paper, I discuss the economic roles of financial reporting, debt covenants, and conservatism within the debt contracting environment, and attempt to fit BWY's findings within this context.