Price Rigidities and Credit Risk

Patrick Augustin, Linxiao Francis Cong, Alexandre Corhay, and Michael Weber

♦ We develop a capital structure model in which firms have a differential flexibility in adjusting output prices to shocks. Inflexible-price firms have lower profits and higher cash-flow volatility, leading in equilibrium to lower financial leverage, shorter debt duration, higher cost of debt, more stringent debt covenants, and higher precautionary cash holdings. Shocks to cash-flow volatility increase the cost of debt more for inflexible-price firms. We confirm these predictions empirically: inflexible-price firms experience a significantly larger increase in credit spreads in response to monetary policy shocks and to the 2008 Lehman Brothers bankruptcy, especially when they face higher pre-shock rollover risk.

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