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Financial Frictions and Risky Corporate Debt
Author(s) -
Ruffino Doriana,
Treussard Jonathan
Publication year - 2007
Publication title -
economic notes
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.274
H-Index - 19
eISSN - 1468-0300
pISSN - 0391-5026
DOI - 10.1111/j.1468-0300.2007.00172.x
Subject(s) - debt , arbitrage , economics , capital structure , corporate debt , monetary economics , interest rate , corporate finance , financial economics , business , finance
We offer clarifications on Cooley and Quadrini (2001) regarding financial frictions and risky corporate debt pricing. Even in a frictionless world, the promised rate on corporate debt is not identical across firms and across capital structures and it is not equal to the risk‐free rate. Frictions are unnecessary for credit spreads to arise. Only if the macroeconomy is in actuality risk free or risk neutral do interest rates on corporate debt reflect default probabilities. To the extent that the firm's entire financial structure is traded, a bias in credit spreads introduces an exploitable arbitrage opportunity. Re‐establishing no‐arbitrage, firm dynamics move in the opposite direction to Cooley and Quadrini's.

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