Winston (Wei) Dou, Finance, The Wharton School; Hongye Guo, Finance, The Wharton School; Hui Chen, MIT Sloan; and Yan Ji, Hong Kong University of Science and Technology
Abstract: Firms tend to compete more aggressively in financial distress; the intensified competition in turn reduces profit margins for everyone, pushing some further into distress. To study such feedback and contagion effects, we incorporate dynamic strategic competition into an industry equilibrium with long-term defaultable debt, which generates various peer interactions: predation, self-defense, and collaboration. Such interactions make cash flows, stock returns, and credit spreads interdependent across firms. Moreover, industries with higher idiosyncratic-jump risks are more distressed, yet also endogenously less exposed to aggregate shocks. Finally, we exploit exogenous variations in market structure — large tariff cuts — to test the core competition mechanism.