New publication for Prof. Morellec in Journal of Financial Economics

© 2019 Herzog - EPFL

© 2019 Herzog - EPFL

The article of Prof. Dr. M. Morellec "Short-term debt and incentives for risk-taking" co-written with Marco Della Seta and Francesca Zucchi has been accepted for publication in the Journal of Financial Economics.

Abstract : We challenge the view that short-term debt curbs moral hazard and analytically demonstrate that, in a world with financing frictions and fair debt pricing, short-term debt increases incentives for risk-taking. To do so, we develop a model in which firms are financed with equity and short-term debt and cannot freely optimize their default decision because of financing frictions. Using this model, we show that short-term debt can give rise to a ``rollover trap," a scenario in which firms burn revenues and cash reserves to absorb severe rollover losses. In the rollover trap, shareholders find it optimal to increase asset risk in an attempt to improve interim debt repricing and prevent inefficient liquidation. These risk-taking incentives do not arise when debt maturity is sufficiently long.

Author: Carole Bonardi