This paper presents a new approach for modeling an optimal debt contract in continuous time. It examines
a competing contract design in a continuous-time environment with Markov income shocks and costly veri
able
information. It shows that an optimal contract has the form of a long-term debt contract that permits a debtor's
strategic default and debt restructuring. The default is characterized by a recurrent, optimal impulse control beyond
default. Numerical examples show that the equilibrium probability of the default is decreasing in the monitoring
technology level when the default causes a big wealth loss.
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