Dynamic Adverse Selection and Belief Update in Credit Markets

Kang, Kee-Youn and Jang, Inkee (2020): Dynamic Adverse Selection and Belief Update in Credit Markets.

Abstract

We develop a dynamic model of debt contracts with adverse selection and belief updates. In the model, entrepreneurs borrow investment goods from lenders to run businesses whose returns depend on entrepreneurial productivity and common productivity. The entrepreneurial productivity is the entrepreneur's private information, and the lender constructs beliefs about the entrepreneur's productivity based on the entrepreneur's business operation history, common productivity history, and terms of the contract. The model provides insights on the dynamic and cross-sectional relation between firm age and credit risk, cyclical asymmetry of the business cycle, slow recovery after a crisis, and the constructive economic downturn.

• Item Type: MPRA Paper
• Language: English
• Keywords: Adverse selection, Bayesian learning, Debt contracts, Belief update
• Subjects: C - Mathematical and Quantitative Methods > C7 - Game Theory and Bargaining Theory > C78 - Bargaining Theory ; Matching Theory; D - Microeconomics > D8 - Information, Knowledge, and Uncertainty > D82 - Asymmetric and Private Information ; Mechanism Design; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E44 - Financial Markets and the Macroeconomy; G - Financial Economics > G0 - General

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