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A Continuous-Time Analysis of Optimal Debt Contracts: Theory and Applications

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  • Hisashi Nakamura

    (University of Tokyo)

Abstract

This paper presents a new approach for modeling an optimal debt contract. It examines a competitive contract design in a continuous-time environment with Markov income shocks and costly verifiable information. It shows that an ex ante optimal contract has the form of a debt contract that permits a debtor’s ex post strategic default. From a viewpoint of creditors, the equilibrium expected default probability is characterized by an exponential distribution, in which the mean arrival rate of default is decreasing in verification costs. When human capital of verification technology is endogenously accumulated, the technology process can be procyclical in equilibirum.

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  • Hisashi Nakamura, 2007. "A Continuous-Time Analysis of Optimal Debt Contracts: Theory and Applications," 2007 Meeting Papers 230, Society for Economic Dynamics.
    • Handle: RePEc:red:sed007:230
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    References listed on IDEAS

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