CIRJE-F-421 "A Continuous-Time Analysis of Optimal Defaultable Debt Contracts: Theory and Applications"
Author Name Nakamura, Hisashi
Date April 2006
Full Paper @
Remarks @ Title changed to "A Continuous-Time Analysis of Optimal Restructuring of Contracts with Costly Information Disclosure" and forthcoming, in Asia-Pacific Financial Markets, SpringerD
Abstract

This paper presents a new approach for modeling continuous-time defaultable debt contracts. It studies an optimal competitive debt contract in continuous time by exploring a dynamic costly monitoring model under asymmetric information in a common-agency setting. It shows that, under an optimal debt contract, a fully informed debtor defaults strategically and recurrently. On the other hand, a less informed creditor expects default to occur stochastically based on an exponential probability distribution under which the arrival rate of default is increasing in monitoring ability. This paper provides a mathematically tractable framework to analyze firms' financial structure and dynamic auditing problems in labor and insurance contracts.