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Financial Frictions and Risky Corporate Debt

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  • Doriana Ruffino
  • Jonathan Treussard

Abstract

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.

Suggested Citation

  • Doriana Ruffino & Jonathan Treussard, 2007. "Financial Frictions and Risky Corporate Debt," Economic Notes, Banca Monte dei Paschi di Siena SpA, vol. 36(1), pages 77-87, February.
    • Handle: RePEc:bla:ecnote:v:36:y:2007:i:1:p:77-87
    DOI: 10.1111/j.1468-0300.2007.00172.x
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    2. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
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