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Market Imperfections, Investment Flexibility, and Default Spreads

Authors

  • Sheridan Titman,

  • Stathis Tompaidis,

  • Sergey Tsyplakov

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    • Titman and Tompaidis are with the McCombs School of Business, University of Texas at Austin. Tsyplakov is with the Moore School of Business, University of South Carolina. We thank seminar participants at New York University, the University of Arizona, the Fields Institute, Instituto Tecnologico Autónomo de Mexico, Duke University, Texas A&M, Southern Methodist University, University of Connecticut, Carnegie Mellon University, Harvard University, the University of Toronto, King's College, the New York Federal Reserve Bank, the 2000 AREUEA meeting, the 2000 FMA meeting in Seattle, the 10th Annual Derivatives Securities Conference, the 2000 EFMA meeting in Athens, the 2001 Real Estate Conference in Vail, the 2001 WFA conference in Tucson, the 2002 RERI conference, the 2002 Real Options conference, Viral Acharya, Andres Almazan, Robert Goldstein, Robert Parrino, Chester Spatt, Suresh Sundaresan, Nancy Wallace, Joe Williams, and an anonymous referee for helpful comments and discussion. We also thank David Fishman, Charter Research, and CB Richard Ellis for providing data, and the Real Estate Research Institute for financial support.

ABSTRACT

This paper develops a structural model that determines default spreads in a setting where the debt's collateral is endogenously determined by the borrower's investment choice, and a demand variable with permanent and temporary components. We also consider the possibility that the borrower cannot commit to taking the value-maximizing investment choice, and may, in addition, be constrained in its ability to raise external capital. Based on a model calibrated to data on office buildings and commercial mortgages, we present numerical simulations that quantify the extent to which investment flexibility, incentive problems, and credit constraints affect default spreads.

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