Scandinavian Working Papers in Economics

Working Paper Series in Economics and Institutions of Innovation,
Royal Institute of Technology, CESIS - Centre of Excellence for Science and Innovation Studies

No 350: Adverse Selection and Search Frictions in Corporate Loan Contracts

Mehdi Beyhaghi (), Babak Mahmoudi () and Ali Mohammadi ()
Additional contact information
Mehdi Beyhaghi: College of Business, University of Texas at San Antonio, Postal: 1 UTSA Circle, , San Antonio, , TX 78249, , United States
Babak Mahmoudi: School of Humanities and Social Sciences, Nazarbayev University, Postal: 53, Kabanbay batyr Ave., , Astana, 010000, , Republic of Kazakhstan
Ali Mohammadi: CESIS - Centre of Excellence for Science and Innovation Studies, Royal Institute of Technology, Postal: CESIS - Centre of Excellence for Science and Innovation Studies, Royal Institute of Technology, SE-100 44 Stockholm, Sweden

Abstract: We provide empirical evidence of both (1) price dispersion and (2) credit rationing in the corporate loan market. We argue that these properties are caused by two factors: an adverse selection resulting from the information asymmetry between lenders and borrowers, and search frictions in matching borrowers with lenders. We develop a model of loan markets in which lenders post an array of heterogeneous contracts, then borrowers tradeoff terms of loan contracts and matching probability between themselves. We show that a unique separating equilibrium exists where each type of borrower applies to a certain type of contract.

Keywords: loan contract; capital structure; debt heterogeneity; adverse selection; competitive search

JEL-codes: D86; G20; G21; G32

30 pages, March 12, 2014

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