Strategic Default Jump as Impulse Control in Continuous Time ( Revised in February 2008 )

Abstract

This paper presents a new approach for modeling an optimal debt contract in continuous time. It examines a competing contract design in a continuous-time environment with Markov income shocks and costly verifiable information. It shows that an optimal contract has the form of a debt contract that permits a debtor's strategic default and reorganization. The default is formulated as an optimal impulse control. This paper provides a useful framework to investigate the debtor's default incentives in relationships to a monitoring technology. Numerical examples show that the equilibrium probability of the default is decreasing in a level of the monitoring technology.