Scandinavian Working Papers in Economics

Discussion Papers,
Norwegian School of Economics, Department of Business and Management Science

No 2011/5: On the Pricing of Performance Sensitive Debt

Aksel Mjøs (), Tor Åge Myklebust () and Svein-Arne Persson ()
Additional contact information
Aksel Mjøs: Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration, Postal: NHH , Department of Finance and Management Science, Helleveien 30, N-5045 Bergen, Norway
Tor Åge Myklebust: Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration, Postal: NHH , Department of Finance and Management Science, Helleveien 30, N-5045 Bergen, Norway
Svein-Arne Persson: Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration, Postal: NHH , Department of Finance and Management Science, Helleveien 30, N-5045 Bergen, Norway

Abstract: Performance sensitive debt (PSD) contracts link a loan's interest rate to a measure of the borrower's credit relevant performance, e.g., if the borrower becomes less credit worthy, the interest rate increases according to a predetermined schedule. We derive and empirically test a pricing model for PSD contracts and find that interest increasing contracts are priced reflecting a substantial risk of shocks to borrower credit quality. Borrowers using such contracts are of an overall higher credit quality compared to borrowers using interest decreasing contracts. These contracts are priced as if no risk of shocks to borrower credit quality is present.

Keywords: Performance sensitive debt; cash flow ratios; credit ratings

JEL-codes: G12; G32

69 pages, First version: March 31, 2011. Revised: May 7, 2012.

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