Showing papers on "Debt published in 1987"

Too Much Investment: A Problem of Asymmetric Information

Abstract: This paper shows that under plausible assumptions, the inability of lenders to discover all of the relevant characteristics of borrowers results in investment in excess of the socially efficient level. Raising the rate of interest above the free market level will restore optimality. This conflicts with generally held views and is contrasted with the Stiglitz-Weiss model. It is shown that the assumptions which yield overinvestment support debt as the equilibrium method of finance. However, under the Stiglitz-Weiss assumptions, used to derive an underinvestment result, equity is shown to be the equilibrium method of finance.

Dynamic Macroeconomic Theory

Abstract: Introduction References and Suggested Readings PART I REAL DYNAMIC MACROECONOMIC MODELS 1. Dynamic Programming A General Intertemporal Problem A Recursive Problem Bellman's Equations Nonstochastic Examples The Optimal Linear Regulator Problem Stochastic Control Problems Examples of Stochastic Control Problems The Stochastic Linear Optimal Regulator Problem Dynamic Programming and Lucas's Critique Dynamic Games and the Time Inconsistency Phenomenon Conclusions Exercises References and Suggested Readings 2. Search Nonnegative Random Variables Stigler's Model of Search Sequential Search for the Lowest Price Mean-Preserving Spreads Increases in Risk and the Reservation Price Intertemporal Job Search Waiting Times Firing Jovanovic's Matching Model Conclusions Exercises References and Suggested Readings 3. Asset Prices and Consumption Hall's Random Walk Theory of Consumption The Random Walk Theory of Stock Prices Lucas's Model of Asset Prices Mehra and Prescott's Finite-State Version of Lucas's Model Asset Pricing More Generally The Modigliani-Miller Theorem Government Debt and the Ricardian Proposition Remarks on Testing and Estimation Conclusions Exercises References and Suggested Readings PART II MONETARY ECONOMICS AND GOVERNMENT FINANCE 4. Currency in the Utility Function The Price of Inconvertible Government Currency in Lucas's Tree Model Issues and Models in Monetary Economics Government Debt in the Utility Function Government Currency in the Utility Function Seignorage and the Optimum Quantity of Currency A Neutrality Proposition Conclusions References and Suggested Readings 5. Cash-in-Advance Models A One-Country Model Fisher Equations Inflation-Indexed Government Debt Interactions of Monetary and Fiscal Policies Interest on Reserves A Two-Country Model Exchange Rate Indeterminacy Conclusions Exercises References and Suggested Readings 6. Credit and Currency with Long-Lived Agents The Physical Setup Optimal Allocations Competitive Equilibrium A Digression on the Balances of Trade and Payments The Ricardian Doctrine about Taxes and Government Debt The Model with Valued Currency and No Private Debt An Interventionist Optimal Monetary Equilibrium Townsend's "Turnpike" Interpretation Conclusions Exercises References and Suggested Readings 7. Credit and Currency with Overlapping Generations The Overlapping-Generations Model The Ricardian Doctrine about Taxes and Government Debt Again A Ricardian Proposition Currency, Bonds, and Open-Market Operations Computing Equilibria Interpretations as Currency Equilibria Optimality Four Examples on Inflation and Its Causes Seignorage and the Laffer Curve Dynamics of Seignorage Forced Saving International Exchange Rates Conclusions Exercises References and Suggested Readings 8. Government Finance in Stochastic Overlapping-Generations Models The Economy Some Examples A General Irrelevance Theorem Wallace's Modigliani-Miller Theorem for Open-Market Operations Chamley and Polemarchakis's Neutrality Theorem Interpretation as a Constant Fiscal Policy Indexed Government Bonds A Ricardian Proposition Further Irrelevance Theorems Conclusions Exercises References and Suggested Readings Appendix. Functional Analysis for Macroeconomics Metric Spaces and Operators First-Order Linear Difference Equations A Formula of Hansen and Sargent A Quadratic Optimization Problem in R A Discounted Quadratic Optimization Problem Predicting a Geometric Distributed Lead of a Stochastic Process Discounted Dynamic Programming A Search Problem Exercises References and Suggested Readings Index

Costly Monitoring, Loan Contracts, and Equilibrium Credit Rationing

Abstract: This paper develops a model with asymmetrically informed agents and costly monitoring of loan contracts, where an equilibrium can exhibit credit rationing. Borrowers are identical ex ante, but some receive loans and others do not. In contrast to existing credit rationing theories, rationing does not occur here due to inflexible prices, adverse selection or moral hazard. Optimizing behaviour produces a standard debt contract in equilibrium. The aggregate quantity of loans and equilibrium interest rates respond differently depending on whether there is rationing in equilibrium.

Corporate Insurance and the Underinvestment Problem

Abstract: A casualty loss produces option-like characteristics in assets because their value depends on further discretionary investment. With risky debt in the firm's capital structure, the shareholders can have incentives to forgo the discretionary investment, even though it has a positive net present value. Thus a potential incentive conflict exists between the bondholders who want the investment made and the shareholders who do not. The incentive problem can be controlled by including a covenant in the bond contract requiring insurance coverage. Full coverage is generally not required. The maximum deductible depends on the amount of debt in the firm's capital structure and the feasible set of net casualty losses.

Corporate Strategy: Useful Perspective for the Study of Capital Structure?

Abstract: The idea of joining strategy literature and financial literature to address the capital structure question arose in two ways. Financial scholars, unable to agree on a desirable mix of debt and equity, have called for managerial inputs. Likewise, strategy scholars have called for inputs from functional areas such as finance. The product of this joint review is a set of propositions suggesting that a strategy perspective might help to explain the capital structure decision.

U.S. Commercial Banks and the Developing Country Debt Crisis

Abstract: The major theme of this paper is that the commercial banks have weathered the debt crisis, while many debtor countries remain in economic paralysis or worse. There is a growing consensus that much of the LDC debt will not be fully serviced in the future, and that consensus is reflected in at least two ways: in the discounts observed in the secondary market prices for LDC debt, and in the discounts in the stock market pricing of banks with exposure in the LDCs.

Bank Foreign Lending, Mandatory Disclosure Rules, and the Reaction of Bank Stock Prices to the Mexican Debt Crisis

Abstract: This paper examines the effects of the Mexican debt mora torium in August 1982 on bank valuation. The Mexican default resulted in the passage of regulations requiring public disclosure of bank fo reign-lending exposure. The authors find that, even in the absence of public disclosure regulations, investors were able to discriminate a mong banks with different levels of exposure. Copyright 1987 by the University of Chicago.

The Default Premium and Corporate Bond Experience

Abstract: The development of organized markets for speculative-grade corporate debt has provided financial researchers with an opportunity to examine the pricing of default risk. By incorporating previous work on the default experience of low-rated corporate debt, this paper presents an introduction to risk-neutral models of risky-bond pricing and uses these to examine the relationship between the default premium embodied in bond yields and actual default rates. The contribution of macroeconomic information to the default premium is also examined. The author finds that holders of low-grade bonds have, on average, been compensated for losses due to default. THE EMERGENCE OF ORGANIZED markets for low-rated corporate (or junk) bonds has provided financial researchers with an opportunity to address a fundamental question: Are holders of default-prone debt compensated (actuarially) for the risk of default? Past research on this market has focused on the default experience of corporate debt. A quite different area of research involves modeling the spreads between the returns of bonds of different credit quality. Few (if any) research efforts have combined these approaches by using actual default experience to explain differential rates of return on low-rated bonds. In this study, a risk-neutral model of the expected probability of default for low-grade bonds is developed as a function of the additional required rate of return on these instruments over default-free bonds. A pricing relationship is derived for the yields to maturity of risky bonds as well as their holding period returns. The default rates implied on corporate bond yields are then compared with a series based on recent corporate bond default experience. Measured holding-period returns, however, are shown to be poor indicators of expected default rates. Next, a "naive" model of expected default rates is suggested as an alternative to the risk-neutral model and subjected to similar tests. Finally, the response of the default premium to changes in the economy is examined. Deviations from expected values of a group of macroeconomic measures will proxy for these changes.

Love Thy Children: Reflections on the Barro Debt Neutrality Theorem

Abstract: This paper proves that Barro's (1974) debt neutrality proposition, whose relevance hinges, in an economy with bequest motives, on bequests being operative in the economy without public debt, is not applicable to a wide class of overlapping generation economies — those with a ‘weak’ bequest motive. In particular, it is shown that the bequest motive is always too weak, and public debt therefore non-neutral, when non-physical assets have a well-defined function (reducing oversavings) in the corresponding economy without bequest motive, i.e., when the non-altruistic economy is dynamically inefficient.

Public Debt Guarantees and Private Capital Flight

Abstract: Significant amounts of private capital have flowed out of several of the more heavily indebted developing countries. This outflow, often called "capital flight ," largely escapes taxation by the borrowing-country government, and has generated concern about the prospects for future servicing of the debt. Imperfect contract enforcement may lead to implicit or explicit government guarantee of foreign debt. The model developed below demonstrates that a government policy of guaranteeing private debt can, in turn, generate more than one outcome. One such outcome replicates the allocation under perfect contract enforcement: national savings is invested domestically and foreign debt is repaid. The tax obligation implied by potential nationalization of private debt, however, can also lead to another outcome in which national capital flees and foreign debt may not be repaid.

Public Debt Guarantees and Private Capital Flight

Abstract: Significant amounts of private capital have flowed out of several of the more heavily indebted developing countries. This outflow, often called "capital flight ," largely escapes taxation by the borrowing-country government, and has generated concern about the prospects for future servicing of the debt. Imperfect contract enforcement may lead to implicit or explicit government guarantee of foreign debt. The model developed below demonstrates that a government policy of guaranteeing private debt can, in turn, generate more than one outcome. One such outcome replicates the allocation under perfect contract enforcement: national savings is invested domestically and foreign debt is repaid. The tax obligation implied by potential nationalization of private debt, however, can also lead to another outcome in which national capital flees and foreign debt may not be repaid.(This abstract was borrowed from another version of this item.)

U.S. commercial banks and the developing-country debt crisis

Abstract: The major theme of this paper is that the commercial banks have weathered the debt crisis, while many debtor countries remain in economic paralysis or worse. There is a growing consensus that much of the LDC debt will not be fully serviced in the future, and that consensus is reflected in at least two ways: in the discounts observed in the secondary market prices for LDC debt, and in the discounts in the stock market pricing of banks with exposure in the LDCs.

Pricing mortgages: An interpretation of the models and results

Abstract: Mortgages, like all debt securities, can be viewed as risk-free assets plus or minus contingent claims that can be usefully viewed as options. The most important options are: prepayment, which is a call option giving the borrower the right to buy back the mortgage at par; and default, which is a put option giving the borrower the right to sell the house in exchange for the mortgage. This article reviews and interprets the large and growing body of literature that applies recent results of option pricing models to mortgages. We also provide a critique of the models and suggest directions for future research.

Managerial Preference, Asymmetric Information, and Financial Structure

Abstract: If firm performance affects managers' wealth or reputation, preferences of managers dominate firms' financing decisions. When information about real asset investment is symmetric, managers finance exclusively with equity. If managers know more about asset quality than do investors and if managers are sufficiently risk averse, they signal high-quality projects with debt. Increases in collateral value decrease risky debt use. Increases in interest rates that do not change productive opportunities increase debt use. The explanation for these and further results is based on underpricing of equity and overpricing of debt at the margin.

Fiscal Rigidities, Public Debt, and Capital Flight

Abstract: This paper associates exchange rate crises and capital flight with the possibility of default on public debt resulting from fiscal rigidities. By including interest-bearing debt, both domestic and external, the model can generate the timing of an attack and can explain why domestic public bonds, even when perfectly indexed, cannot eliminate the possibility of a crisis. This fiscal framework provides explanations for the simultaneity of private capital flight and public foreign borrowing and wide observed fluctuations in real exchange rates, with recent Mexican experience as illustration.

Risk‐Shifting Incentives and Signalling Through Corporate Capital Structure

Abstract: This paper examines optimal corporate financing arrangements under asymmetric information for different patterns of temporal resolution of uncertainty in the underlying technology. An agency problem, a signalling problem and an agency-signalling problem arise as special cases. The associated informational equilibria and the optimal financing arrangements are characterized and compared. In the agency-signalling equilibrium the private information of corporate insiders at the time of financing is signalled through capital structure choices which deviate optimally from agency-cost minimizing financing arrangements, which in turn induce risk-shifting incentives in the investment policy. In the pure signalling case the equilibrium is characterized by direct contractual precommitments to implement investment policies which are riskier than paretooptimal levels. Empirical implications for debt covenants and the announcement effect of investment policies and leverage increasing transactions on existing stock and bond prices are explicitly derived. THIS PAPER is an exploratory attempt to relate optimal corporate financing arrangements to patterns of temporal resolution of uncertainty in the underlying technology. Since, in general, the timing of the uncertainty resolution could be different for different agents (say corporate insiders vs. outsiders) some of the issues which arise are those of financing under asymmetric information. However, a systematic analysis of the implications for corporate finance of the interaction of private information and temporal resolution of uncertainty has not been undertaken.' It is hoped that such a program of research will yield better answers to questions of timing of various corporate financing decisions. For instance, is there an optimal maturity structure of corporate claims (debt claims in particular) to be used to finance a technology with given characteristics? Why are projects in their initial phase often financed differently from projects in more advanced phases? For example, growth firms use a larger component of retained earnings for their financing than mature firms, and project financing (incorporated as legally segregated entities) is often used for the start-up phase of some ventures to switch later to more conventional modes. Why do leveraged buy-outs often * New York University and University of Chicago. Earlier versions of this paper have benefitted from the helpful comments of Chris Blake, Yuk-Shee Chan, Gene Fama, Larry Glosten, Rob Heinkel, Max Maksimovic, Merton Miller, Bani Mishra, David Nachman, Roy Radner, Marti Subrahmanyam, Tommy Tan, Joseph Williams and participants in seminars at Buffalo, Baruch, Illinois, Maryland, NYU, Ohio State and the AFA, EFA, and WFA. Financial support in the early stages of the project from a Batterymarch fellowship and later stages from a Salomon Brothers fellowship and an

The Growth of Public Debt: Sustainability, Fiscal Rules, and Monetary Rules

Abstract: The paper first addresses the question of the sustainability of debt growth by examining the behavior of taxation implied by fiscal rules that respect a government's intertemporal budget constraint. Sustainable debt growth may require the tax burden to rise above some socially acceptable level. In this case, whereas drastic remedies may prove ineffective, a more relevant choice concerns the degree of monetary financing of the deficit (as distinct from monetization of the debt), which affects the dynamics of taxation implied by the constraint. Monetary financing is then introduced into a model by Blanchard, and the effects of monetary financing on the interest rate and capital intensity are examined. Finally, some policy implications are considered.

The End of the Month as a Preferred Habitat: A Test of Operational Efficiency in the Money Market

Abstract: This paper argues that an aggregate preferred habitat for investors exists on (or about) the last day of the calendar month, due to standardizations in the nation's payments system resulting in a concentrated flow of funds on this date. Thus, equilibrium yield discounts are predicted for securities maturing on such dates. Empirical tests on monthly and daily Treasury bill data support the principal hypothesis, as well as several ancillary hy? potheses. The results have implications for Treasury debt management, for the short-term cash and debt management practices of businesses and banks, and for the empirical esti? mation of daily, weekly, or monthly return premiums on risky securities.

Recent Developments in International Banking and Finance

Abstract: Overview (S.J. Khoury). Innovation in the Financial Markets (S.A. Ross). Corporate Takeovers: Winners, Losers, and Some Remaining Issues (E. Han Kim). Current Structure and Recent Developments in Foreign Exchange Markets (J.B. Burnham). On Political Risk - The Turnover Tax on the Swedish Money and Bond Markets or How to Kill a Market without really Trying (J.A. Lybeck). Time-Varying Risks Premiums in Forward Exchange Rates and Deviations from PPP (H.B. Kazemi). Currency Movements and Corporate Pricing Strategy (A.K. Sundaram and V. Mishra). Technical Strategies in Foreign Exchange Markets: An Interim Report (R.J. Sweeney). Should International Portfolios be Permanently Hedged? (M. Adler and M.R. Granito). A Reexamination of the Benefits to International Diversification (R.D. Marcus, D. Solberg and T.L. Zivney). Linkages of National Stock Markets: Statistical Evidence Before, During and After the October 1987 Crash (A.G. Malliaris and J.L. Urrutia). Information and Price Adjustment Processes: A Comparison of U.S. and Japanese Stocks (A. Damodaran). Valuation of Swaps (S. Sundaresan). Exchange Rate Jumps and Currency Options Pricing (A.L. Tucker). Exchange Rate Uncertainty and Precommitment in Symmetric Duopoly: A New Theory of Multinational Production (S.J. Khoury, D. Nickerson and V. Sadanand). Debt Over Hang and the Efficiency of International Rescheduling (R.M. Giammarino and E. Nosal).

Til Debt Do Us Part: The U.S. Capital Market and Foreign Lending, 1920-1955

Abstract: This paper analyzes United States experience with foreign lending in the half-century from 1920. A first question raised by this experience is what triggered the process of United States foreign lending. I conclude that lending was restrained at the beginning of the period by the debt overhang associated with reparations and by the post World War I disruption of international trade. Intervention by creditor country governments in the form of the Dawes Loan, League of Nations loans to Central Europe and reconstruction of the gold standard system was needed to initiate long-term capital flows. A second question is how to characterize the operation of the United States capital market once lending was resumed. I conclude that while lenders discriminated among potential borrowers and demanded compensation for default risk, their efforts in this respect proved insufficient. Neither an efficient-markets nor a fads-and-fashions model provides an adequate characterization of the data. A third question is whether default in the 1930s made it more difficult for countries to borrow in the 1940s and 1950s. I find no evidence that countries which interrupted debt service in the 1930s found it more difficult to borrow subsequently than did countries which continued to service their debts. Instead, both defaulting and non-defaulting countries found their access to private portfolio capital flows reduced as a result of defaults.

Lower-Grade Bonds: Their Risks and Returns

Abstract: To reflect as realistically as possible the risks and returns of lower-grade bonds, the authors constructed an index from actual average returns used in the compilation of the Salomon Brothers and Drexel Burnham Lambert lower-grade indexes, supplementing these with month-end prices prior to 1982 from the SP thus a diversified portfolio may contain both the debt and equity of the issuing companies.

Aggregate demand contractions with nominal debt commitments: is wage flexibility stabilizing?

Abstract: When nominal debt payments commitments exist, output losses following an aggregate demand contraction will be larger and more persistent. Paradoxically, output can be less stable if wages are more flexible. This occurs because falling wages and prices cause debtors' cash flow to deteriorate relative to their debt commitments. To reduce the chance of incurring bankruptcy costs, debtors cut expenditure. Creditor's wealth increases from an unexpected deflation but their gain does not offset debtors' loss because of the increased threat of bankruptcy and associated costs. Net wealth and aggregate demand fall, magnifying the effect of the initial contraction.