TY - JOUR
T1 - Transitory and Permanent Cash Flow Shocks in Debt Contract Design
AU - Ma, Le
AU - Sikochi, Anywhere
AU - Xiao, Yajun
N1 - Publisher Copyright:
© The Author(s), 2025. Published by Cambridge University Press on behalf of the Michael G. Foster School of Business, University of Washington.
PY - 2025
Y1 - 2025
N2 - We examine how lenders design contracts to account for transitory and permanent cash flow shocks facing borrowers. We find that volatile transitory cash flow shocks are associated with fewer liquidity covenants, indicating financial flexibility that enables firms to survive liquidity crunches. The opposite is true for volatile permanent cash flow, suggesting that borrowers' economic fundamentals are important credit risk factors. Subsequent analyses show that borrowers exposed to transitory (permanent) shocks face less (more) severe credit consequences following poor performance. Overall, we show that transitory and permanent cash flow shocks have significant and opposite effects on debt contract covenant design.
AB - We examine how lenders design contracts to account for transitory and permanent cash flow shocks facing borrowers. We find that volatile transitory cash flow shocks are associated with fewer liquidity covenants, indicating financial flexibility that enables firms to survive liquidity crunches. The opposite is true for volatile permanent cash flow, suggesting that borrowers' economic fundamentals are important credit risk factors. Subsequent analyses show that borrowers exposed to transitory (permanent) shocks face less (more) severe credit consequences following poor performance. Overall, we show that transitory and permanent cash flow shocks have significant and opposite effects on debt contract covenant design.
UR - http://www.scopus.com/inward/record.url?scp=85218883228&partnerID=8YFLogxK
U2 - 10.1017/S0022109024000474
DO - 10.1017/S0022109024000474
M3 - Article
AN - SCOPUS:85218883228
SN - 0022-1090
JO - Journal of Financial and Quantitative Analysis
JF - Journal of Financial and Quantitative Analysis
ER -