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| When Do Firms Default? A Study of the Default Boundary by Sergei A. Davydenko of the University of Toronto August 1, 2007 Abstract: This paper studies whether default is triggered by low market asset values or by liquidity shortages, corresponding to economic versus financial distress. Default is often assumed to occur when market assets fall below a certain boundary. Consistent with this hypothesis, some low-value firms default despite sufficient liquidity. However, liquidity shortages can precipitate default at high asset values when firms are restricted from accessing external financing. Moreover, many distressed firms do not default for years. As a result, even though boundary-based default predictions can match observed average default frequencies, they misclassify a large number of firms in cross-section. JEL Classification: G21, G30, G33. Keywords: Credit risk, Default boundary, Liquidity, Default, Covenants. Download paper (475K PDF) 53 pages |
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