Discussion Paper Details

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Title: Optimal Debt Contracts under Costly Enforcement

Author(s): Hans K Hvide and Tore Leite

Publication Date: January 2007

Keyword(s): Costly state verification, debt contract, priority violation and strategic defaults

Programme Area(s): Financial Economics

Abstract: We consider a financing game with costly enforcement based on Townsend (1979), but where monitoring is non-contractible and allowed to be stochastic. Debt is the optimal contract. Moreover, the debt contract induces creditor leniency and strategic defaults by the borrower on the equilibrium path, consistent with empirical evidence on repayment and monitoring behaviour in credit markets.

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Bibliographic Reference

Hvide, H and Leite, T. 2007. 'Optimal Debt Contracts under Costly Enforcement'. London, Centre for Economic Policy Research.