Strategic Default Jump as Impulse Control in Continuous Time

Discussion Papers are a series of manuscripts in their draft form. They are not intended for circulation or distribution except as indicated by the author. For that reason Discussion Papers may not be reproduced or distributed without the written consent of the author. 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 long-term debt contract that permits a debtor's strategic default and debt restructuring. The default is characterized by a recurrent, optimal impulse control beyond default. Numerical examples show that the equilibrium probability of the default is decreasing in the monitoring technology level when the default causes a big wealth loss.