Incentive incompatibilities and arbitrage opportunities

Purpose - The paper aims to examine the practical importance of the finding of Mayers and Smith, that underinvestment is a problem when debt exposed to bankruptcy is part of the financial structure.Design methodology approach - The paper examines critically the assumptions underlying the Mayers and...

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Bibliographic Details
Published in:The journal of risk finance 2008-11, Vol.9 (5), p.422-431
Main Author: Venezian, Emilio
Format: Article
Language:English
Subjects:
Analysis
Arbitrage
Cash flow
Debt
Demand
Discount rates
Equity
Financial management
Insurance
Investments
Net present value
Purchasing
Stockholders
Studies
Supply and demand
Underinsurance
Citations: Items that this one cites
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Summary:Purpose - The paper aims to examine the practical importance of the finding of Mayers and Smith, that underinvestment is a problem when debt exposed to bankruptcy is part of the financial structure.Design methodology approach - The paper examines critically the assumptions underlying the Mayers and Smith paper.Findings - The necessary assumption of deterministic arbitrage in the market for productive properties used by Mayers and Smith in their model is found to be unrealistic. Even if that assumption were valid, however, the result of Mayers and Smith establishes that raising exposed debt is a negative net present value project for the investor and hence that form of financing would not be found in practice.Practical implications - The existence of exposed debt does not explain the demand or commercial insurance.Originality value - The paper challenges the results of Mayers and Smith that have been used to examine the effect of debt on insurance demand for almost 20 years with mixed results.
ISSN:1526-5943
2331-2947
DOI:10.1108/15265940810916094