Extend the debt as it is not deeply out-of-the-money

Wei-Hsiung Wu (), Hui-Hwang Tsai (), Shyan-Yuan Lee () and Son-Nan Chen
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Wei-Hsiung Wu: Department of Finance, Ming Chuan University
Hui-Hwang Tsai: Graduate School of Department of Finance, National Taiwan University
Shyan-Yuan Lee: Department of Finance, National Taiwan University

Economics Bulletin, 2008, vol. 7, issue 16, 1-6

Abstract: In this paper, we modify the extendible debts model proposed in Longstaff (1990) to help relieve the moral hazard problem induced in the original model. In Longstaff¡¦s model, extending the maturity of the defaulted debts gives the borrower an incentive to default even if the borrower is insolvent. In this paper, we argue that the debt should not be extended if it is defaulted severely. We have shown that the extendible debt valuation can be obtained by the compound option pricing besides the PDE approach. We also have derived the fair interest rate of the extendible debts in this paper.

JEL-codes: G0 G2 (search for similar items in EconPapers)
Date: 2008-11-02
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