Investment incentives and risk sharing properties of debt and equity contracts in international financial markets

Abstract

This paper examines the risk sharing and investment incentive properties of debt and equity contracts in international financial markets. Using a Nash bargaining framework between the borrower and its lenders, debt repayment after renegotiation is derived. Renegotiable debt contracts provide better investment incentives than equity contracts, when the level of debt is not very high. For high levels of debt, when repayment due is above a renegotiated debt repayment, disincentives for investment arise. Risk sharing between lenders and borrowers is better under equity contracts when investment takes place and debt contracts are not renegotiated.