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Optimal Debt Contracts with Renegotiation
Author(s) -
Usman Murat
Publication year - 2004
Publication title -
journal of economics and management strategy
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.672
H-Index - 68
eISSN - 1530-9134
pISSN - 1058-6407
DOI - 10.1111/j.1430-9134.2004.00031.x
Subject(s) - debt , monetary economics , recourse debt , investment (military) , internal debt , debt to gdp ratio , debt levels and flows , economics , microeconomics , external debt , business , finance , politics , political science , law
This paper sutudies the role of debt in committing a seller not to trade at a low price. We consider a discrete‐time finite‐horizon buyer–seller relationship. The seller makes an upfront relationship‐specific investment, which is financed with debt. Debt then is repaid gradually to mitigate the hold‐up risk. Even though debt is renegotiable, under the assumption that with a small probability renegotiation may fail and may lead to inefficient liquidation, debt still can be used as a commitment device. We solve for renegotiation proof dynamic debt contracts that are optimal for the seller and show that debt is repaid over the entire course of the relationship with declining repayments .