Financial Contracting as Behavior Towards Risk

Abstract

This paper describes a business cycle model where financial contracting with interrelated covenants is the mechanism by which bondholders and stockholders confront the risks associated with future production-investment decisions and financing decisions of the firm and in the process resolves a conflict of interest problem between them. In resolving this conflict of interest problem the interrelated covenants in the financial contract shape the financial facts of business cycles. The model set-up includes two agents (bondholders and stockholders), two decisions (production-investment decisions and financing decisions), and two equilibrium conditions (market equals economic book value for both bonds and stocks). In this 2x2x2 set-up the manager of the representative firm should always make production-investment decisions that conform to the risk aversion of stockholders and then use financing decisions to offset any effect of a change in operating risk on the market valuation of bonds. Preliminary evidence from the U.S. nonfinancial corporate sector does not reject the predictions of the model.