Journal of Economic Dynamics & Control 39 (2014) 98112

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Journal of Economic Dynamics & Control

journal homepage: www.elsevier.com/locate/jedc

Credit risk and asymmetric information:

A simplified approach
Snorre Lindset a,n, Arne-Christian Lund b, Svein-Arne Persson c
a
b
c

Norwegian University of Science and Technology, Department of Economics, Dragvoll NTNU, 7491 Trondheim, Norway
Norwegian School of Economics, Department of Business and Management Science, Helleveien 30, 5045 Bergen, Norway
Norwegian School of Economics, Department of Finance, Helleveien 30, 5045 Bergen, Norway

a r t i c l e in f o

abstract

Article history:
Received 31 August 2011
Received in revised form
31 October 2013
Accepted 5 November 2013
Available online 15 November 2013

We present a simple model for risky, corporate debt. Debtholders and equityholders have
incomplete information about the financial state of the debt issuing company. Information
is incomplete because it is delayed for all agents, and it is asymmetrically distributed
between debtholders and equityholders. We solve for the equityholders' optimal default
policy and for the credit spreads required by debtholders. Delayed information accelerates
the equityholders' optimal decision to default. Interestingly, this effect is small, implying
only a small impact on credit spreads. Asymmetric information, however, has a major
impact on credit spreads. Our model predicts high credit spreads for short-term debt, as
observed empirically in credit markets.
& 2013 Elsevier B.V. All rights reserved.

JEL classification:
G12
G33
Keywords:
Default policy
Credit spreads
Incomplete information

1. Introduction
The risk of monetary losses due to debt issuers who do not honor contractual debt payments is commonly referred to as
credit risk and explains the existence of credit spreads.
We present a theoretical model of credit spreads for corporate debt, where debtholders and equityholders have
incomplete information about the financial state of the company. The information is incomplete because the true state of the
issuer is only revealed with a time delay (delayed information). In addition, the information is asymmetrically distributed in
cases where debtholders and equityholders observe the true state with different time delays. The model is structural, and in
contrast to the seminal structural models, it predicts that also short-term credit spreads can be wide, in line with empirical
findings.
A (rational) default policy describes when the equityholders (rationally) choose not to service contractual debt payments.
We find that the length of the information delay for equityholders is not important for the default policy. The delay is
therefore not important for credit spreads either. The degree of information asymmetry, however, i.e., the difference in the
length of the information delay between debtholders and equityholders, is of crucial importance for credit spreads.
On a more general level, our paper addresses how incomplete information influences the pricing of bonds. We do not
consider noisy information, only delayed information. One can always argue that noisy information in many circumstances

Corresponding author.
E-mail address: snorre.lindset@svt.ntnu.no (S. Lindset).

0165-1889/$ - see front matter & 2013 Elsevier B.V. All rights reserved.
http://dx.doi.org/10.1016/j.jedc.2013.11.006

S. Lindset et al. / Journal of Economic Dynamics & Control 39 (2014) 98112

99

is more common than delayed information. However, our main focus in this paper is on which aspects of information
structures that are important to obtain realistic models of credit spreads, and not on the realism of different information
structures.
One assumption of our model is that equityholders are better informed than debtholders. This assumption is based on
the idea that equityholders are closer to the day-to-day operations of the company than the debtholders, and, thus, receive
information earlier than debtholders. Although we can visualize cases where this may not be the situation (e.g., a company
may have passive owners), we find it plausible that the best informed equityholder is better informed than the best
informed debtholder. Debtholders must assess the value of the company based on less information than the equityholders,
but they rationally include the observation whether the company is bankrupt or not in their assessment.
In the special case where debtholders and equityholders have complete information, i.e., there is no delay in the flow of
information, our model simplifies to the classical Leland (1994) model. The current paper is also inspired by, and closely
related to, the seminal Duffie and Lando (2001) model of credit risk. Our model includes continuously observed, but delayed
information about the state variable, where the true state is immediately, i.e., without a delay, revealed upon bankruptcy.
The model of Duffie and Lando (2001) includes noisy (accounting) information released at discrete points in time. They
assume that equityholders have complete information and, thus, that only debtholders are subject to incomplete (noisy)
information. Their model, as ours, includes incomplete and asymmetric information, but does not explicitly cover the case
where all agents are subject to delayed information. We simplify the Duffie and Lando (2001) model by excluding noisy
(accounting) information, and extend it by explicitly exposing all agents to delayed information.
The main merit of our paper is that we identify information asymmetry, and not delay, noise, or other characteristics of
the information, as the important property for a simple and realistic model of corporate credit spreads. This insight also
refines the results by Choi (2008), who studies some aspects of delayed information (he uses the terminology lagged) in a
similar set-up.
Structural models were pioneered by Merton (1974). Merton models the value of a company's assets by a stochastic
process and debt and equity are considered as contingent claims on total asset value. Some of the papers in this tradition
include Black and Cox (1976), Geske (1977), Longstaff and Schwartz (1995), Leland (1994), and Duffie and Lando (2001).
In our model the default policy is expressed by an endogenous default barrier. Giesecke (2006) analyzes two classes of
models of imperfect information: (1) Models where the bankruptcy barrier is not observable to all agents.1 (2) Models with
incomplete information about the value of the company's assets. Our model belongs to his category (2), and according to his
Proposition 6.4, a default intensity exists in our model. Default intensities are important for reduced-form models. These
types of models were pioneered by Jarrow and Turnbull (1992), for extensions see e.g., Jarrow and Turnbull (1995), Jarrow
et al. (1997), and Schnbucher (1998).2 Papers analyzing technical aspects about credit risk and incomplete information
include Coculescu et al. (2008) and Guo et al. (2009). Other issues related to credit risk are analyzed in Rosen and Saunders
(2009), Huang and Yu (2010), and Azizpour et al. (2011).
Jarrow and Protter (2004) argue that the difference between structural and reduced form essentially is the assumption of
what information the modeler has access to. In their terminology, a model is structural if the modeler can observe the state
of the company, and reduced form if he cannot. They write (page 2): there appears to be no disagreement that the asset
value process is unobservable by the marketAlthough not well understood in terms of its implications, this consensus
supports the usage of reduced form models. Our results indicate that if different groups of agents have access to the same
incomplete information about the process, the error made by using a structural model compared to a reduced form model,
interpreted as in Jarrow and Protter (2004), is negligible.
The paper is organized as follows: In Section 2 we present our economic model. Section 3 presents optimal default policy
and credit risk valuation. Special cases with numerical examples are presented and analyzed in Section 4. Section 5
concludes the paper and gives suggestions for future research.

2. Economic model
This section presents our model of a company with incomplete information about the credit quality of its debt. Because
our focus is on default policy and debt valuation, we do not address whether debt is issued in an optimal way, i.e., whether
the capital structure of the issuer is optimal or not. Our model is standard, and we follow closely the set-up by Leland (1994)
and Duffie and Lando (2001).
Our model consists of two distinct groups of agents, equityholders and debtholders. In general, the two groups do not
have access to the same information and there is no information leakage between the two groups. Equityholders have at
least as much information as debtholders and constitute the group of better informed agents. The debtholders are the less
informed agents. To rule out the possibility that debtholders extend their information set by buying equity, we (as Duffie and
Lando, 2001) assume that equity is not traded. Furthermore, we assume that equityholders do not buy debt from the
company because debtholders could potentially extract information from such transactions. Also, it would alter the
1

See also Giesecke and Goldberg (2004) for more on this.

Comprehensive treatments of these two approaches can be found in the encyclopedic monograph by Bielecki and Rutkowski (2002) or in the more
accessible monograph by Duffie and Singleton (2003).
2

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S. Lindset et al. / Journal of Economic Dynamics & Control 39 (2014) 98112

equityholders' optimization problem that we analyze below. The company is run by the equityholders, i.e., the model does
not distinguish between owners and management. A decision to stop servicing debt and file for bankruptcy is endogenously
made by equityholders. Furthermore, all agents in the economy are assumed risk neutral and therefore discount future
cashflows by the constant, continuously compounded risk free interest rate r.
We assume that the only state variable is the stock of assets. It is given as the solution to the stochastic differential
equation
dSt St dt sSt dBt ;

S0 4 0;

where or, s, and S0 are constants. Here, the process B fBt gt Z 0 is a standard Brownian motion defined on a fixed, filtered
probability space ; F ; F0 ; P, where F0 fF t gt Z 0 . The process S fSt gt Z 0 is known as a geometric Brownian motion and St
is log-normally distributed. Also, P represents the objective probability measure. The information at time t is given by the
s-algebra F t . Here F t is generated by the process fSu ; 0 ru rtg. Thus, F0 represents the complete information filtration and
satisfies the usual conditions.
l
The information available at time t for the two groups of agents are given by s-algebras F m
t and F t . Superscripts m and l
signify more and less information. We denote the starting point in time of our economic analysis by t0. Define real numbers l
and m such that 0 rm rl rt 0 , and the s-algebras by
Fm
t F t  m;

for all t Z t 0

and
F lt F t  l ;

for all t Zt 0 :

Clearly, from this specification the s-algebras can be nested as

F lt D F m
t DFt:
Thus, in the case m 40, also equityholders have incomplete information about the state variable, whereas in the case m0,
equityholders have complete information. We interpret m as a measure of information delay and l m as a measure of
information asymmetry. Thus, information delay refers to the delay in the information available to the better informed
agents, whereas information asymmetry refers to the difference in the information delay between the two groups of agents.
m
The filtration Fm
t 0 fF t gt Z t 0 represents the development of available information for the equityholders.
m
m
An m-delayed stopping time with respect to Fm
t 0 is a function t 0 : -t 0 ; 1 such that f t 0 rtg A F t  m for all t Zt 0 .
Similarly, in the case of m 0, we let t 0 be a classical (non-delayed) stopping time. Furthermore, we denote optimal
m
stopping times by m
. As usual, T denotes the set of all classical
n t 0 and the set off all m-delayed stopping times by T
stopping times. In our economic model we interpret the optimal stopping time as the default time, i.e., the time of
bankruptcy.
At any time debtholders observe whether a bankruptcy has taken place. Debtholders use this information rationally and
formally we define the debtholders' extended information set as
Glt F lt 3 s1fm
n t 0 4ug; u r t;
where 1fg denotes the usual indicator function. The filtration Glt0 fGlt gt Z t 0 represents the development of available
information for the debtholders.
Consider first an unlevered firm, i.e., a company without debt. The stock of assets generates a continuous stream of
dividend payments to the equityholders. The rate at which dividends are paid at time t is St  m , for some constant 40.
Observe that the dividend rate at time t is determined by the delayed value St  m . The time t value of the stock of assets is
unobservable to the equityholders if m 40. The interpretation of the term stock of assets must be done in a broad sense.
In our model it represents the quantity which determines the dividend payments to equityholders. It is therefore an
indicator of the cash generating ability of the company's assets. It could depend on a number of factors such as the technical
condition of the company's production machinery, competence of employees, loyalty of customers, competitors, and market
conditions, as well as other non-financial factors relevant for the company's ability to pay dividends. The stock of assets is
usually not readily observable. Equityholders must gather, process, and analyze information in order to assess its value. This
assessment process takes time and, in practice, the stock of assets is observed with a delay, much in accordance with
our model.
m
The time t present value of all future dividends, Vt , is
Z 1

St  m
:
2
Vm
e  ru  t Su  m dujF m

t
t E
r 
t
m

Observe that the present value Vt is just a multiple of St  m . Either one of these quantities could therefore be used as the
m
state variable. The quantity Vt is sometimes called the unlevered value of the company and in our setting it represents the
equityholders' assessed value of the stream of dividends.
The rate of dividends paid at time t, St  m , is observed by debtholders first at time t l m, alternatively, at time t they
observe dividends paid at time t  l  m. If debtholders could observe dividends at the time they are paid, they could
calculate the equityholders' assessed value of the company, and thereby eliminate the information asymmetry.

S. Lindset et al. / Journal of Economic Dynamics & Control 39 (2014) 98112

101

At the time of bankruptcy, m

n , the value of the company is immediately revealed and publicly available. We define the
liquidation value of the company as
V mn V 0mn

Smn
;
r 

i.e., as the unlevered value of the company given full information at the time of bankruptcy. This value does not take any
effects of possibly optimally restructured debt at bankruptcy into account. Furthermore, at the time of bankruptcy, a
bankruptcy cost Smn =r , A 0; 1, proportional to the liquidation value of the company occurs.
As in Leland (1994), we assume that the company has issued perpetual debt with face value D. The debt is serviced by a
constant rate of coupon payments C. These payments are tax deductible (only interest is paid on perpetual debt). The tax
benefit rate is C, where is the tax rate. For a levered firm, i.e., a company with debt, the time t net dividend rate to equity
holders is St  m  1  C, and can take both positive and negative values.
3. Optimal default policy and credit risk valuation
3.1. Bankruptcy wild card
In the event of bankruptcy, the debtholders claim the amount identical to the face value of the debt D. According to
absolute priority, debtholders' claims have priority over equityholders' claims.
Due to the information delay, there is a positive probability that the liquidation value of the company is more than
sufficient to cover debt and bankruptcy costs, i.e., the event
V mn V mn D 4 0
has positive probability. Any positive amount, in excess of debt and bankruptcy costs, is the property of the equityholders.
3
with payoff
By deciding to file for bankruptcy at time m
n , the equityholders obtain a bankruptcy wild card
1  =r  Smn  D . This payoff is similar to the payoff of a European call option on 1  =r  units of the stock
of assets. It is straight forward to calculate its value using valuation theory for stock options.
From standard properties of geometric Brownian motions, the complete-information value of the stock of assets at the
m
m
bankruptcy time m
n , Sn , expressed as a function of the delayed value of the stock of assets observed by equityholders, Sn  m ,
is given by
 1=2s2 m sBm  Bm  m

Smn Smn  m e

and is log-normally distributed. The time m

n value of the bankruptcy wild card is expressed in closed form in Proposition 1.
m
Proposition 1. Given default at time m
n , the time n value of the bankruptcy wild card is




 m


1 
F m
Smn  D
Smn  m E
n

r 
p

1  m
e Smn  m Nz  DN z  s m ;

r

where
ln
z


 

1  Smn  m
1
s2 m
2
r  D
p
s m

and N is the cumulative standard normal probability distribution function.

Proof. The result follows from the standard BlackScholesMerton formula for a European call option, but without
discounting because the payoff is received instantaneously at the time of bankruptcy.
3.2. Optimal default policy
The decision to file for bankruptcy is taken by the equityholders. Equityholders maximize the value of the equity by
determining when to default on the debt payments.
We now conjecture that the optimal stopping time is a first hitting time for a constant Wm, i.e., the company is bankrupt
and liquidated the first time St  m W m . Observe that Wm is defined relative to the state variable, i.e., the stock of assets.
The information delay is illustrated in Fig. 1. The black line shows observed asset values given complete information. The
grey line shows asset values as observed by equityholders. In particular, observe that the equityholders make the
3

This wild card has some resemblance to the wild card play that is present when trading the CBOT Treasury bond futures, see e.g., Hull (2012, p. 135).

102

S. Lindset et al. / Journal of Economic Dynamics & Control 39 (2014) 98112

Fig. 1. Illustration of information delay. Black line shows observed asset values given complete information, and grey line shows observed asset values
given delayed information.
m
bankruptcy decision at time m
n when they observe an asset value equal to W . With no delay, the equityholders would have
defaulted earlier, i.e., at time n when the asset value equals W (assuming that W W m ).
At any time t Z t 0 (assuming that the company is not bankrupt at time t) the equityholders face the optimal stopping
problem:
"Z m
#
t
m
e  rv  t Sv  m  1 C dv e  r t  t Sm  m jF m
St  m sup E
5
t :

m t A T m

The first term inside the expectation operator in expression (5) is the discounted value of the dividends, net of after-tax
coupon payments. The second term is the present value of the bankruptcy wild card. There are three differences between
the optimization problem in expression (5) and the standard complete information optimization problem, see e.g., Duffie
(2001), Chapter 11.C. The first is the inclusion of the bankruptcy wild card in the optimization problem. Second, the delayed
state variable St  m enters, and third, the optimization is based on less information (F m
t ) than the standard case with
complete information (F t ).
The optimal stopping problem with delayed information can be transformed into an optimal stopping problem with nondelayed information (see ksendal, 2005). The relationship between the optimal stopping time n from the non-delayed
m
problem and the optimal stopping time m
n from the delayed problem is given by n n m. We can then write
 Z t  m
e  rv  t  m Sv  1 C dv:
St  m sup E
t  m A T
tm

6
e  rt  m  t  m S jF t  m :
By substituting u t  m in the problem (6) we obtain
Z u

e  rv  u Sv  1 C dv e  ru  u S jF u ;
Su sup E
u A T

for u Zt 0  m. We recognize expression (7) as a standard optimal stopping problem. To summarize, the equityholders'
optimization problem with delayed information has been transformed into an equivalent optimization problem with nondelayed information. The latter problem can be solved using standard methods.
The solution to problem (7) satisfies the HamiltonJacobiBellman equation
ss 12 s2 s2 ss  r s  1  C 0;

where s St , and subscripts denote partial derivatives, i.e., s s=s, ss s=s , together with the boundary
conditions
2

W m W m

and
s W m W m ;

10

where  is given in expression (4) and W m denotes the derivative of  with respect to the state variable, evaluated at
the point Wm. Eqs. (9) and (10) are known as the value matching and the high contact (or smooth pasting) conditions,
respectively.
Before we introduce two technical conditions, we first define
x
x


C1 


p

1  m

D
e Nz 1 
x
N z s m ;

r 
1 C
1  C

S. Lindset et al. / Journal of Economic Dynamics & Control 39 (2014) 98112

where
ln
z

103


 

1  x
1
s2 m
r  D
2
p
s m

and o 0 is a constant defined below. Here, x is essentially a weighted sum of the value of the bankruptcy wild card from
expression (4), , and its derivative.
Condition 1. Assume that 1 em Nz o j 1j and that W m o=r  1=r  .
Condition 2. Assume that 1 em Nz 4 j 1j and that W m 4=r  1=r  .
Loosely speaking, Condition 1 is relevant for (relatively) small values of the delay m, whereas Condition 2 may be
relevant for larger values of m.
In Proposition 2 we state the solution to problem (7).
Proposition 2. Assume that either Condition (1) or (2) is satisfied. Problem (7) has the following solution: the optimal stopping
time is given by
n u inf ft Z u : St r W m g
with respect to the filtration Fu . The value of equity is
8



 


m

 s
s
C
s
>
< s  W
1
 1 
Wm
m
m
m
r
W
W
s r  r  W
>
:0
where

1 2
s 
2

for s Z W m ;

11

for s o W m ;

s

2
1
 s2 2rs2
2
o0;
s2

is the negative root of the quadratic equation

1 2
2 s  1 r

0:

The constant default barrier Wm is implicitly given by the equation



C
1  W m
r
W

;

 1 W m
r 
m

12

where the function  is given in expression (4).

Proof. See Appendix B.
We remark that the connection between the optimal stopping time n from the non-delayed problem given in
m
Proposition 2 and the corresponding optimal delayed stopping time m
n , observable by the equityholders, is n n m.
m
As usual, the factor s=W is interpreted as the present value of 1 payable upon default, given current state s. The total
value of equity can therefore nicely be interpreted as the present value of dividends until default, from which the after tax
present value of coupons until default is deducted, and the present value of the bankruptcy wild card is added. The only
difference between the above solution and the classical solution is the addition of the bankruptcy wild card, which
complicates the solution so that, in general, no explicit solution for Wm is available. However, if there exists a solution to
Eq. (12), it is easy to find it numerically.
When m0, the bankruptcy wild card has no value and the expression for the default barrier W simplifies to
W

r  1  C
:
1
r

13

3.3. Credit risk valuation

The only credit sensitive asset issued by the company is a loan. The debtholders belong to the less informed group of
agents and assess the fair terms of the loan. The loan is securitized into a continuum of zero-coupon bonds, where the
continuum is with respect to the time to maturity. Duffie and Lando (2001) explain the connection between perpetual debt
and a continuum of zero-coupon bonds with finite maturities and an example of such a connection is further elaborated in

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S. Lindset et al. / Journal of Economic Dynamics & Control 39 (2014) 98112

Appendix C. Throughout the paper we analyze one such zero-coupon bond with fixed maturity. The bond matures at time T,
m
with recovery function Rm
n ; T in the case of default at time n o T. The price of the bond consists of two parts:
1. The discounted value of the principal paid at maturity.
2. The discounted value of the recovery payment in case of default.
More formally, the time t price of a bond maturing at time T Z t is the conditional expected discounted payoff, i.e.,
 r
t; T Ee  rT  t 1fm
n t 4 Tg e

 rT  t

 t

l
Rm ; T1fm
n t rTgjGt 

Pn t 4 TjGlt 1 ;
m

Pn t 4 TjGlt
m

14
4

where we interpret
as the survival probability of the company until time T. In the second equality, we have
used the recovery function Ru; T 1  e  rT  u , u A t; T, i.e., the same recovery function as in Duffie and Lando (2001).
This recovery function facilitates analytical solutions of bond prices and is therefore used throughout the paper.
For a credit risky zero-coupon bond, the credit spread l;m is defined as the excess yield compared to the yield on a
riskfree zero-coupon bond. From expression (14) we have that
e  r

l;m T

 t

l
e  rT  t Pm
n t 4TjGt 1  ;

l;m

l
 lnPm
n t 4 TjGt 1 
:
T t

so
15

l
Notice that the credit spread vanishes as -0 and tightens as the survival probability Pm
n t 4 TjGt increases.

4. Special cases and numerical examples

In this section we look at four special cases and provide some numerical examples. Condition 1 is satisfied in all the
examples. We start with the simplest case, i.e., the base-case with complete information. Here we have no information
asymmetry, l  m 0, and no information delay, m 0. This case serves as a benchmark case. We then look at the most
general case with information asymmetry, l  m 4 0, and information delay, m 4 0. We end this section by looking at the
cases with (1) information asymmetry, but no information delay, l  m 4 0, m 0, and (2) no information asymmetry, but
information delay, l m 0, m 4 0. The numerical examples in this section are based on the parameter values in Table 1. For
these parameter values we are able to solve Eq. (12) for delays m o15:4 years.
In the 12 year period from 1995 to 2007, the average recovery rate for senior secured loans in the US was 72.3%, while the
corresponding recovery rate for high yield bonds was 42.2%, cf. Altman et al. (2004). Our model does not include an
exogenously specified recovery rate parameter. Instead, the use of a bankruptcy cost parameter induces different
(expected) recovery rates, depending on the numerical values of the other parameters that are used. A tax rate of 30% seems
reasonable for many companies. A volatility of 30% means that the instantaneous standard deviation of the log-returns of
the stock of assets is 30% (with the base-case parameters, also the instantaneous standard deviation of the log-return of V is
30%). Some of the parameters are altered in the numerical examples.
Collin-Dufresne et al. (2010) find that since 1937 only four companies have defaulted on bonds with an investment grade
rating from Moody's. This empirical observation suggests that realistic values of the information asymmetry l  m is not too
large. With a sufficiently large information asymmetry, even a company with bonds rated investment grade may have time
to move into default.5
4.1. The base-case (l m 0; m 0)
In this case there is neither information asymmetry, nor information delay, both debtholders and equityholders have
perfect information. Thus, Glt F m
t F t . If r and 0, this case corresponds to the model by Leland (1994). Also, with
r 4 and 4 0, this is a well-known case and serves well as a benchmark case when delayed information is included in the
subsequent subsections.
Equityholders are faced with the same optimal stopping problem as in expression (5), but the bankruptcy wild card is not
present (it has zero value). The value matching and the high contact conditions therefore become W 0 and s W 0.
The solution for W is given in expression (13).6 For the base-case parameter values, W65.
By the definition of Glt , the survival probability includes information regarding any observed defaults prior to, and including, time t.
This observation also gives some justification for using a model with a diffusion process instead of a jump-diffusion process. Few companies jump
into default when their bonds are rated investment grade. However, it should be pointed out that many bonds jump several categories down to junk rating
from investment grade and default shortly thereafter. This happened to Enron who defaulted from a junk rating, but who was rated investment grade 2
days before it defaulted.
6
In the special case considered by Leland (1994), W 1 C=r 0:5s2 .
4
5

S. Lindset et al. / Journal of Economic Dynamics & Control 39 (2014) 98112

105

Table 1
Base-case parameters.
St 0  m

C
D

100
0.035
0.08
0.045
0.3
0.3
0.5
13
90

Initial value of stock of assets

Fraction of stock of assets paid as dividend
Riskfree interest rate
Growth rate of stock of assets
Volatility of stock of assets
Tax rate
Bankruptcy cost parameter
Coupon payment
Face value of debt

Spread
0.175
0.150
0.125
0.100
0.075
0.050
0.025

0.00

0.25

0.50

0.75

1.00

1.25

1.50

1.75

2.00

2.25

2.50

2.75

3.00

Time to maturity (in years)

Fig. 2. Credit spreads base case with complete information. The figure shows credit spreads, expression (15), for zero-coupon bonds with up to 3 years to
maturity. The tax rates are 20% (widest spreads), 30%, and 40% (tightest spreads).

Bond prices are calculated by expression (14) with m l 0. Thus,

t; T Pn t 4 TjF t T  t; lnW=St ;
where an analytical expression for ;  is given in expression (A.1) in Appendix A.
In Fig. 2 we plot the credit spreads for bonds with maturities between 0 and 3 years for three different levels of the tax
rate : 20%, 30%, and 40%. The widest credit spreads are required for the lowest tax rate and the tightest spreads for the
highest tax rate. The explanation for this observation is that, ceteris paribus, lending money is less risky when the tax rate is
high because the value of the tax-shield from interest payments is worth more to equityholders and they will therefore wait
longer, i.e., accept lower dividend payments before they default on their loan payments. The survival probability is
increasing in the tax rate.
Observe how the credit spreads vanish as the time to maturity approaches zero, a typical property of structural models of
credit risk, but it contradicts empirical observations in credit markets.

4.2. The general case (l  m 4 0; m 40)

We now assume that both information asymmetry and information delay are present, i.e., both groups of agents have
incomplete information about the value of the state variable, and the information is asymmetrically distributed between the
two groups. More formally, Glt  F m
t  F t.
The bankruptcy barrier is not a function of the current value of the state variable. Thus, even though equityholders are
better informed than debtholders, also debtholders can calculate Wm. Denote the minimum value of the process S over a
period u; v by M u;v , i.e.,
M u;v minfSt ; u r t rvg:
The survival probability, as seen from the debtholders' point of view, is given by
m
l
m
l
Pm
n t 4TjGt P n t 4TjM t  l;t  m 4W ; F t :

16

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S. Lindset et al. / Journal of Economic Dynamics & Control 39 (2014) 98112

Using Baye's rule, expression (16) can be written as

m

 Pm t 4T 4 T \ M
l
t  l;t  m 4 W jF t
l
n
P m
n t 4 TjGt
m
l
PM t  l;t  m 4 W jF t

PM t  l;T  m 4W m jF lt
PM t  l;t  m 4 W m jF lt
T  m  t l; lnW m =St  l
;
l m; lnW m =St  l

17

where the expression for ;  is given in expression (A.1) in Appendix A.

Assume the same parameter values as in Table 1. In addition, l 0.4. Fig. 3 shows the credit spreads for m 0.1 (widest
spreads), m 0.2, and m 0.3 (tightest spreads with solid line, the dotted line represents the complete-information case
(base-case)). For all cases, Wm 65 (with at least 4 zeros after the decimal point). Note in particular how asymmetric
information leads to wider credit spreads for short-term bonds.
It may at first seem counter intuitive that the spreads decrease as equityholders become less informed (m increases).
However, recall that the degree of asymmetric information between debtholders and equityholders, l  m, decreases as m
increases. Thus, the decrease in credit spreads is a result of a decreased degree of asymmetric information.
In Fig. 4 we check how sensitive the default barrier and the value of the bankruptcy wild card are to the delay. In the
figure we vary the delay m from 0 to 4 years. Corporations usually announce financial results quarterly, so realistic values of
the delay should probably be less than 1 year.
From Fig. 4, (a) and (b), we see that even a delay of 1 year has only a negligible effect on the optimal default barrier Wm.
The graphs are increasing in the delay, but they are rather flat for reasonable values of the delays, in particular for 0:5,
suggesting that the delay has only a low influence on the optimal default barrier. A higher volatility leads to a lower default
barrier, but volatility does not seem to be important for the slope of the graphs.
The bankruptcy wild card is essentially a call option and its value is therefore non-decreasing in volatility, cf. Fig. 4(c) and (d).
The probability that the bankruptcy wild card matures in-the-money decreases in the bankruptcy cost parameter . The value of
the bankruptcy wild card is therefore decreasing in . This fact also explains why the default barrier is more sensitive to the
delay when is low: the more economically lucrative the alternative to still run the company is, the earlier will the
equityholders default on the debt payments.
4.3. DuffieLando (l m 40; m 0)
In this case there is information asymmetry, but no information delay. Similar to the model by Duffie and Lando (2001),
the information structure is as follows: Glt  F m
t F t.
When no information delay is present, i.e., m 0, the bankruptcy wild card is not present and the default barrier is W, the
same as in the case of complete information (see Section 4.1). Thus, the survival probability is given in expression (17) with
m 0.
If we use the base case parameters and plot credit spreads for l 0.1, l 0.2, and l 0.3, we get a figure identical to Fig. 3.
The explanation is that the information asymmetry l  m is the same as in the previous subsection, i.e., these values of l are
the same as the values of l  m in previous subsection. In addition, the value of the bankruptcy wild card is not significant for
the base case parameters. We show later that in cases where the delay m is sufficiently long, the optimal default barrier and
credit spreads in the present case and in the general case in Section 4.2 differ.
Spread
0.10

0.08

0.06

0.04

0.02

0.00

0.25

0.50

0.75

1.00

1.25

1.50

1.75

2.00

2.25

2.50

2.75

3.00

Time to maturity (in years)

Fig. 3. Credit spreads general case. The figure shows credit spreads, expression (15), for zero-coupon bonds with up to 3 years to maturity. The information
delays m are 0.1 (widest spreads), 0.2, and 0.3 (tightest spreads) and l 0.4. The lower, dotted line represents the complete-information case.

S. Lindset et al. / Journal of Economic Dynamics & Control 39 (2014) 98112

100

100 W

90

90

80

80

70

70

60

60

50

50

40

40

30

30

20

20

10

10
0.0

0.5

1.0

1.5

2.0
m

2.5

3.0

3.5

0.0

4.0

m
4.0 (W)

4.0

3.5

3.5

3.0

3.0

2.5

2.5

2.0

2.0

1.5

1.5

1.0

1.0

0.5

0.5
0.0

0.5

1.0

1.5

2.0
m

2.5

3.0

3.5

4.0

107

0.5

1.0

1.5

2.0
m

2.5

3.0

3.5

4.0

1.0

1.5

2.0
m

2.5

3.0

3.5

4.0

(W )m

0.0

0.5

Fig. 4. Optimal default barrier Wm and the value of the bankruptcy wild card W m for different levels of information delay m and volatility s for two
different levels of the bankruptcy parameter . The s values range from 0.2 to 0.7 with intervals of 0.1. (a) The optimal default barrier Wm as a function of m
for 0:5. Lower graph is for higher volatility. (b) The optimal default barrier Wm as a function of m for 0:3. Lower graph is for higher volatility. (c) The
value of the bankruptcy wild card W m as a function of m for 0:5. Higher graph is for higher volatility. (d) The value of the bankruptcy wild card W m
as a function of m for 0:3. Higher graph is for higher volatility.

4.4. Case of symmetrically delayed information (l m 0; m 4 0)

The final case includes delayed information, but with no information asymmetry. The information is symmetrically
distributed between debtholders and equityholders, i.e., l m; m 40.
Bonds are priced using the survival probability in expression (17). Because l m, the expression simplifies to
m
l
m
m
Pm
n t 4TjGt P n t 4TjF t T  t; lnW =St  m ;

18

where the expression for ;  is given in expression (A.1) in Appendix A. By comparing this expression with the
corresponding expression for the case of full information, the only way symmetric, but delayed information, can affect credit
spreads is through a change in the default barrier Wm, i.e., if W m aW.
In Fig. 5, the credit spreads for the four cases are plotted for three different assumptions about the lengths of the delays.
In parts (a)(d) the credit spreads for the cases complete information and symmetrically delayed information are not
distinguishable. The same is true for the cases DuffieLando and the general case. Comparing the plots (c) and (d) to the
plots (a) and (b), we clearly see that a higher degree of asymmetric information leads to wider credit spreads. Also, by
comparing the plots (b) and (d) to the plots (a) and (c), it is clear that a lower bankruptcy cost parameter tightens credit
spreads, cf. the definition of credit spreads in expression (15).
To visualize different credit spreads for the four cases, we must increase the information delay significantly (to m 2 in
the example), see parts (e) and (f) in Fig. 5. The reason for different spreads in the different cases is that the delay m is so
long that Wm is sufficiently different from W to also affect credit spreads. Note in particular in part (f) of the figure how
credit spreads in the symmetrically delayed case are tighter than the spreads in the DuffieLando case for m o0:5 and wider
for m 4 0:5.
5. Conclusions and suggestions for future research
In this paper we have proposed a new model for incorporating delayed and asymmetric information between
debtholders and equityholders. We articulate the effect of delayed information on shareholders' endogenous decision to

108

S. Lindset et al. / Journal of Economic Dynamics & Control 39 (2014) 98112

0.12

Spread

0.12

0.10

0.10

0.08

0.08

0.06

0.06

0.04

0.04

0.02

0.02

0.00 0.25 0.50 0.75 1.00 1.25 1.50 1.75 2.00 2.25 2.50 2.75 3.00

0.00 0.25 0.50 0.75 1.00 1.25 1.50 1.75 2.00 2.25 2.50 2.75 3.00

Time to maturity (in years)

Time to maturity (in years)

0.12

Spread

0.12

0.10

0.10

0.08

0.08

0.06

0.06

0.04

0.04

0.02

0.02

0.12

Spread

Spread

0.00 0.25 0.50 0.75 1.00 1.25 1.50 1.75 2.00 2.25 2.50 2.75 3.00

0.00 0.25 0.50 0.75 1.00 1.25 1.50 1.75 2.00 2.25 2.50 2.75 3.00

Time to maturity (in years)

Time to maturity (in years)

Spread

0.12

0.10

0.10

0.08

0.08

0.06

0.06

0.04

0.04

0.02

0.02

Spread

0.00 0.25 0.50 0.75 1.00 1.25 1.50 1.75 2.00 2.25 2.50 2.75 3.00

0.00 0.25 0.50 0.75 1.00 1.25 1.50 1.75 2.00 2.25 2.50 2.75 3.00

Time to maturity (in years)

Time to maturity (in years)

Fig. 5. Examples of credit spreads for the four cases. In plots (a)(d), the widest spreads are for the two cases with asymmetric information. In plots (e) and
(f) (for m o 0:5), the widest spreads are for the general case, followed by the DuffieLando case, the symmetrically delayed information case, and the
tightest spreads for the case with complete information. (a) No information delay, moderate information asymmetry, s 0:3, l  m 0:2, m 0, 0:5.
(b) No information delay, moderate information asymmetry, s 0:3, l  m 0:2, m 0, 0:3. (c) Moderate information delay, moderate information
asymmetry, s 0:3, l  m 0:4, m 0.2, 0:5. (d) Moderate information delay, moderate information asymmetry, s 0:3, l  m 0:4, m 0.2, 0:3.
(e) Long information delay, moderate information asymmetry, s 0:3, l  m 0:2, m2, 0:5. (f) Long information delay, moderate information
asymmetry, s 0:3, l  m 0:2, m 2, 0:3.

default. In particular, for realistic parameter values we show that incomplete information to equityholders about the true
stock of asset value only has a small effect on their decision to default on the loan payments. Any effect is likely to accelerate
a default. The decision to default is accelerated because by defaulting, equityholders receive a bankruptcy wild card with
non-negative value. This wild card gives the equityholders a valuable alternative to continued operation of the company.
If both debtholders and equityholders have access to the same delayed information, the only reason for changed credit
spreads is a potential change in equityholders' optimal default policy, compared to the complete-information case. For
realistic parameter values, these changes are small. Furthermore, we find that asymmetric information between debtholders
and equityholders is important for credit spreads, far more important than delayed, symmetrically distributed information.
Increased information asymmetry leads to wider credit spreads. Our model produces short-term credit spreads more in line
with empirical observations than most standard structural models of credit risk.
The results in this paper have empirical testable implications: Do companies where there is likely to be more asymmetric
information between debtholders and equityholders pay higher interest rates on their loans? Do companies where there is

S. Lindset et al. / Journal of Economic Dynamics & Control 39 (2014) 98112

109

more uncertainty about asset values, i.e., a higher degree of incomplete information, default earlier than other companies?
One indication that may lead to a confirmative answer to the last question is if equityholders tend to receive payments from
the bankruptcy wild card more often than equityholders of companies with a lower degree of incomplete information. Our
model also predicts that companies with high bankruptcy costs, for instance because of relatively illiquid assets, wait longer
before they default. A typical reason for illiquid assets is a high degree of asset specificity.
For future extensions of the results in this paper, it would be interesting to include management as a third group of
agents. Management would always belong to the better informed group. With three groups of agents, we could for instance
assume that debtholders and equityholders both belong to the less informed group of agents. With this assumption, we
could extend the analysis to also include companies whose equity is traded in a financial market. Unfortunately, this
assumption makes the model harder to solve.

Acknowledgement
The authors would like to thank Fred Espen Benth, Carl Chiarella, Darrel Duffie, Hans Marius Eikseth, Steinar Ekern, Chris
Florackis, Nadine Gatzert, Kay Giesecke, Jrgen Haug, Kristian Miltersen, Aksel Mjs, Jril Mland, yvind Norli, and
Per stberg. In particular, thorough comments from anonymous referees have substantially improved the paper. Earlier
versions have been presented at faculty seminars at Trondheim Business School, the Norwegian School of Economics,
Princeton University, the University of Stavanger, Norwegian University of Science and Technology, Department of
Economics, European Financial Management Association Annual Meeting in Athens 2008, European Group of Risk and
Insurance Economists Meeting in Toulouse 2008, and at Workshop on Innovations in Stochastic Analysis and Mathematical
Finance Norwegian School of Economics 2013.
Appendix A. Survival probability
Consider a geometric Brownian motion with dynamics as in expression
(1) with initial value S0, and a barrier sb o S0 .

Consider also the arithmetic process with dynamics dX t  12 s2 dt s dBt , starting at X 0 0. The first time the process S
hits sB is equivalent to the first time Xt hits x lnsB =S0 . The probability for the process S of not crossing the barrier sb in a
time period of length v is identical to the probability for the process X fX t gt Z 0 of not crossing the barrier x lnsB =S0 in a
time period of length v and is




 x v
x v
2
p
p ;
v; x N
e2x=s N
A:1
s v
s v
where  12 s2 , see e.g., Musiela and Rutkowski (1997, Corollary B.3.4) .
Appendix B. Proof of Proposition 2
To prove that the solution of expression (11) is optimal, we follow the approach in Duffie and Lando (2001).
The function s in expression (11) (for s Z W m ), with Wm implicitly given in expression (12), satisfies Eq. (8) and the
boundary conditions (9) and (10).
We now consider  as a function of s, where s has dynamics given in expression (1). As Duffie and Lando (2001), we
apply It's lemma to s to get


ds s s 12 s2 s2 ss dt s ss dBt :
We define
qt; St e  rt  t0  m St

t
t0  m

e  rv  t0  m Sv  1 C dv:

Applying It's lemma to qt; St , writing s St , we get


dqt; s e  rt  t0  m s s 12 s2 s2 ss  r
s  1  C dt s ss dBt :

B:1
m

The dt-term in the above expression is zero from the HamiltonJacobiBellman equation (8) for s ZW . We now show
that both conditions (1) and (2) imply that the dt-term of Eq. (B.1) is non-positive for s o W m . In this case s ss 0.
The dt-term of Eq. (B.1) simplifies to s  1 C. Now, s  1 C r0 for all s o W m if W m  1 C r0. Inserting Wm from
expression (12) and simplifying we get the sufficient condition



Wm
r 1  C
r 1:
B:2
1 W m

r 

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S. Lindset et al. / Journal of Economic Dynamics & Control 39 (2014) 98112

Assume first that W m =o j  1j=r  . Then (B.2) can be written as



1
W m W m

Z

Wm ;
r r 

1  C
where  is defined in Section 3.2. Assume now that W m =4 j  1j=r  . Then (B.2) can be written as


1
W m W m

r

Wm :
r r 

1  C
Either of these conditions, called conditions 1 and 2 in Section 3.2, is sufficient to ensure that the dt-term of expression (B.1)
is non-positive.
Rt
To show that the dBt-term of expression (B.1) is a martingale, we show that Y t  t0 s St sSt dBt defines a martingale
with respect to the filtration Ft0  m . From expression (11) we calculate s St and find that
s St St ASt BSt ;
where the constants A =r  and B  W m =r  . Here, Yt is a martingale if
Z T

Z T

Z T

ASt BSt 2 dt A2 E
S2t dt 2ABE
S1t dt
E
t0

t0

Z
B2 E

T
t0

t0

S2
t dt o 1:

B:3

q
RT
It is well known that E t0 X 2t dt o1 for Xt log-normally distributed. Here, St, S1t , and St are all log-normally distributed.
Hence, each of the three expectations on the right-hand side of expression (B.3) is well defined and Yt defines a martingale
with respect to the filtration Ft0  m .
From the above arguments it follows that qt;  is a super-martingale with respect to Ft0  m , i.e.,
qt 0 m;  Z EqU; jF t0  m , for any stopping time U A T . Recall that T is the set of all Ft 0  m stopping times.
We calculate
Z n t 0  m

e  rv  t0  m Sv 1  C dv e  rn t 0  m  t0  m Sn t0  m jF t 0  m
E
t0  m









 St 0  m
St 0  m W m St0  m
C
St 0  m
1

1 
W m
m
m
m
r
r 
r  W
W
W

St0  m :
The first equality follows from the definition of n t 0  m in Proposition 2 and calculations.
At any point in time u, the continuation value Su must be at least as high as the value of stopping at u, Su , so
Su Z Su :

B:4

Finally, we have for any stopping time U that

St 0  m qt 0  m; St0  m Z EqU; SU jF t0  m 
Z U

e  rv  t0  m Sv 1  C dv e  rU  t0  m SU jF t 0  m
E
Z
ZE

t0  m
U
t0  m


e  rv  t0  m Sv  1  C dv e  rU  t0  m SU jF t0  m :

The two equalities follow from the definitions of q;  and St 0  m in expression (11). The first inequality is due to the fact
that qt;  is a super-martingale with respect to Ft0  m . The second inequality follows from the inequality (B.4).
Thus, we have verified that the candidate solution (11) is optimal.
Appendix C. Connection between perpetual debt and zero-coupon bonds
In this appendix we assume complete information and show one example of a portfolio of a continuum of zero-coupon
bonds which has the same value as a perpetual debt contract.
Consider perpetual debt with coupon rate C to be paid until the company defaults. The company defaults on its debt
payments the first time the stock of assets in Eq. (1) hits the default barrier W from above. The time of default is given by the
stopping time
n inf ft : St rWg;
tZ0

defined with respect to F0 and where W is given in expression (13).

S. Lindset et al. / Journal of Economic Dynamics & Control 39 (2014) 98112

111

The parameter determines bankruptcy costs, i.e., bankruptcy costs are =r  W. The value of the debt at time 0 can
be calculated as
Z n

1 
W
C:1
E
Ce  rs ds e  rn
r
0
with solution

 
C
C 1 
S0


W
;
r
r
r 
W
where is given in Proposition 2, cf. Black and Cox (1976).
Observe that we can also write expression (C.1) as

Z n 

1 
1 
W e  rs ds
W:
C r
E
r 
r 
0

C:2

The natural interpretation of expression (C.1) is the sum of the present value of coupon payments until default and the
present value of the recovery amount 1  =r  W upon default.
Expression (C.2) suggests that the recovery amount 1 =r  W may instead be paid at time 0, but where interest
payment for this amount has to be deducted from the coupon C until default, without changing the overall value of the debt.
Our next step is to securitize the perpetual debt into a continuum of zero-coupon bonds. Let NT be the number of zerocoupon bonds maturing at time T, and let NT N for all T A 0; 1. The time 0 value of a continuum of N zero-coupon bonds
with expiration at time T and with general recovery function Rn ; v if o v is
Z n



Z 1
Ne  rt dt NE e  rn
Rn ; t dt :
0 N E
0

The first term represents the present value of the zero-coupon bonds which expire before default. The second term
represents the present value of the recovery amounts of the unexpired bonds upon default.
Consider now the particular recovery function used in this paper, Rn ; v 1  e  rv  n . In this case the above
expression simplifies to
Z n

Z 1

Ne  rt dt N1  E
e  rt dt
0 N E
n
Z 0n

1    rn
E e
Ne  rt dt N
E
r
Z0 n

1
 rt
:
C:3
E
Ne
dt N
r
0
Consider now a portfolio composed of two parts, a continuum of N C r1  =r  W= zero-coupon bonds and a
time 0 bank deposit (equivalently, the bank deposit can be zero-coupon bonds maturing at time 0) of
1 =r W  1 =C=r 1  =r  W. The time 0 value of this portfolio follows from expression (C.3) and is



Z n 

1 
1  C 1 
W e  rt dt

W
0 E
C r
r 

r
r 
0


1 
1  C 1 
W

W

r 

r
r

Z n 

1 
1 
W e  rt dt
W;
E
C r
r 
r 
0
which is identical to the time 0 value of perpetual debt from expression (C.2).
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