Insolvency, Illiquidity, and the Risk of Default Sergei A. Davydenko∗ Preliminary February 2013 Abstract This paper studies whether default is triggered by insolvency (low market asset values relative to debt) or by illiquidity (low cash reserves relative to current liabilities), corresponding to economic versus financial distress. Although most firms at default are distressed both economically and financially, the two factors are distinct: A quarter of defaults are either by insolvent firms with abundant cash, or by solvent firms in a cash crisis. Consistent with the core assumptions of structural models of risky debt, the market value of assets is the most powerful factor explaining the timing of default by far, outperforming most other commonly used variables put together. By contrast, the marginal contribution of illiquidity is much smaller and depends on financing constraints that restrict the firm’s access to external financing. Keywords: Credit risk; Structural models; Default; Insolvency; Illiquidity; Cash shortage; Default boundary JEL Classification Numbers: G21, G30, G33 ∗Joseph L. Rotman School of Management, University of Toronto. Email:
[email protected]; Phone: (416) 978-5528. Financial support from the Social Sciences and Humanities Research Council (SSHRC) is gratefully acknowledged. Introduction This paper studies the role of insolvency (economic distress) and illiquidity (financial distress) in triggering corporate default. I look at whether the two factors are distinct, how they interact, and to what extent they explain empirically observed defaults. Understanding what precipitates default is central to the analysis of capital structure, financial reor- ganization, and credit risk. Assumptions about the conditions that result in default are always present, either explicitly or implicitly, in any discussion involving risky debt.