Rollover Risk and Credit Risk

Abstract

This paper models a firm's rollover risk generated by conflict of interest between debt and equity holders. When the firm faces losses in rolling over its maturing debt, its equity holders are willing to absorb the losses only if the option value of keeping the firm alive justifies the cost of paying off the maturing debt. Our model shows that both deteriorating market liquidity and shorter debt maturity can exacerbate this externality and cause costly firm bankruptcy at higher fundamental thresholds. Our model provides implications on liquidity-spillover effects, the flight-to-quality phenomenon, and optimal debt maturity structures.

The Hazards of Debt: Rollover Freezes, Incentives, and Bailouts

“…12 This results in a lower ex ante value of debt, equity and total 11 More formally, the expected number of creditors that get to act between now and the next maturity time is independent of δ, as it is a product of the expected time 1 δ and the flow of maturing creditors per unit of time δ. 12 As noted in He and Xiong (2009a), y * A 's monotonicity in δ disappears for situations with low drift and extremely firm value for short maturities, as plotted in the upper right panel, lower right panel, and lower left panel, respectively. In each of these panels, value is increasing in maturity 1/δ.…”

“…Denote the equilibrium rollover threshold in this constrained model by y * A . He and Xiong (2009a) establish that there is a unique equilibrium in cutoff strategies where creditors refuse to roll over for y < y * A . Figure 3 plots y * A for different values of 1/δ.…”

“…The important feature about the firm's debt financing is that the firm staggers the maturity of its debt: rather than having all creditors' debt contracts mature at the same time, only a fraction of debt comes due at each point in time. As noted in He and Xiong (2009a), many financial firms spread out the maturity of their debt expirations, often for liquidity reasons.…”

“…We choose the dynamic debt run model of He and Xiong (2009a) as our building block for liabilityside risk. This choice is motivated by two considerations: first, the dynamic nature allows for treatment of volatility, and, second, the model provides a robust unique equilibrium, which allows us to model incentives with runs in an integrated framework.…”

“…The staggered nature of debt creates "liability-side risk" in the form of debt runs (He and Xiong, 2009a). 2 Intuitively, staggered short-term debt creates an intertemporal coordination problem, or low "creditor confidence," where creditors refuse to roll over their debt when firm fundamentals are sufficiently low.…”