Price Rigidities and Credit Risk? - Michael Weber

Finance

Speaker : Michael Weber (Chicago Booth)

We develop a capital structure model in which firms feature differential flexibility in adjusting output prices to shocks. Inflexible-price firms have lower profits and higher cash-flow volatility, leading in equilibrium to lower financial leverage, shorter debt duration, higher cost of debt, more stringent debt covenants, and higher precautionary cash holdings. Moreover, a cash-flow volatility shock increases the cost of debt more for inflexible-price firms. We confirm these predictions empirically and exploit the 2008 Lehman Brothers bankruptcy to show that inflexible-price firms with higher pre-shock rollover risk exposure experience a significantly larger increase in credit spreads following the event than other firms.