The Hazards of Debt: Rollover freezes, incentives, and bailouts

Ing Haw Cheng, Konstantin Milbradt*

*Corresponding author for this work

Research output: Contribution to journalReview articlepeer-review

33 Scopus citations

Abstract

We investigate the trade-off between incentive provision and inefficient rollover freezes for a firm financed with short-term debt. First, debt maturity that is too short-term is inefficient, even with incentive provision. The optimal maturity is an interior solution that avoids excessive rollover risk while providing sufficient incentives for the manager to avoid risk-shifting when the firm is in good health. Second, allowing the manager to risk-shift during a freeze actually increases creditor confidence. Debt policy should not prevent the manager from holding what may appear to be otherwise low-mean strategies that have option value during a freeze. Third, a limited but not perfectly reliable form of emergency financing during a freeze - a "bailout" - may improve the terms of the trade-off and increase total ex ante value by instilling confidence in the creditor markets. Our conclusions highlight the endogenous interaction between risk from the asset and liability sides of the balance sheet.

Original languageEnglish (US)
Pages (from-to)1070-1110
Number of pages41
JournalReview of Financial Studies
Volume25
Issue number4
DOIs
StatePublished - Apr 1 2012

ASJC Scopus subject areas

  • Accounting
  • Finance
  • Economics and Econometrics

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