The aim of this thesis is to price and construct the optimal debt contract between two parties, the owner of the company and its creditor. Within the subject of credit risk this is a topic that has gotten a lot attention since its importance is high for almost every firm, and especially for financial firms as their whole being relies upon giving loans to other companies. By introducing the traditional model of Merton the aspect of pricing is touched upon. But since Merton’s model has its limitations, for instance its assumption about a perfect loan market, models by Leland are introduced to move slightly closer to the reality of how firms operate. Leland’s models introduce default costs, tax benefits and a capital structure, which can change after its initial settlement. Here debt is priced after the optimal capital structure has been settled, and endogenous default boundaries are defined. Last an optimal risk strategy is defined, as it is shown that the timing of the strategy affects the payoffs both parties receive. To move yet another step closer to reality, renegotiation is introduced. The element of renegotiation is important, since it is rarely seen that the creditor lets the firm default without having tried to give it a helping hand thru for instance letting it pay no or smaller monthly installments for a periods of time. The creditor will only agree to renegotiate, if his gains by accepting the deal covers the losses he will have for a period of time. Control allocation is then implemented in the initial debt contract, as it can be thought that in future the owner and the creditor will have their disagreements about what decisions to make regarding the firms ongoing. The aim is to construct an (pareto) optimal contract which protects both parties from the other party’s opportunistic behavior. The aim of the paper is not to define a single optimal contract, as the definition of optimal highly relies on what parameters and circumstances are current. However optimal debt contracts have been deducted by defining certain circumstances, and if a single parameter is changed so will the optimal debt contract.
|Educations||MSc in Mathematics , (Graduate Programme) Final Thesis|
|Number of pages||72|