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How Good are Standard Debt Contracts? Stochastic Versus Nonstochastic Monitoring in a Costly State Verification Environment

Working Paper 512 | Published December 1, 1993

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Authors

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John H. Boyd

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Bruce D. Smith

How Good are Standard Debt Contracts? Stochastic Versus Nonstochastic Monitoring in a Costly State Verification Environment

Abstract

We investigate ex-ante efficient contracts in an environment in which implementation is costless. In this environment, standard debt contracts will typically not be optimal. Optimal contracts may involve defaults, even in states in which the borrower is fully able to repay. We then examine the welfare costs of arbitrarily restricting the set of feasible contracts to standard debt contracts. When model parameters are calibrated to realistic values, the welfare loss from exogenously imposing this restriction is extremely small. Thus, if the implementation costs are actually nontrivial (as seems likely), standard debt contracts will be (very close to) optimal.


Published in: _The Journal of Business_ (Vol. 67, No. 4, October 1994, pp. 539-561), https://doi.org/10.1086/296646.