Risk And The Role Of Collateral In Debt Renegotiation

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Executive Summary

In his basic model of debt renegotiation, Bester [1994] argues that collateral is more effective if high risk projects are financed. This result, however, crucially depends on the definition of risk. Using the second-order stochastic dominance criterion introduced by Rothschild and Stiglitz [1970], the authors show that it is not a project's high risk, induced by a high probability of default that makes collateral more effective. Instead it turns out that, given the expected return; the probability of default has no impact on the collateral's effectiveness. Moreover, a higher risk of the project caused by a higher loss given default makes the use of collateral even less effective.

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