Winston Wei Dou

Feedback and Contagion through Distressed Competition

Joint with Hui Chen, Hongye Guo, Yan Ji

March 2020

Firms tend to compete more aggressively when they are in financial distress; the intensified competition reduces the profit margins for all firms in the industry, pushing everyone further into distress. To study such feedback and contagion effects, we incorporate supergames of competition into a model of long-term debt and strategic default. Depending on the relative market share and financial strength as well as entry threats, firms in the model exhibit a rich variety of strategic interactions, including predation, self-defense, and collaboration. A key result of our model is that, due to financial contagion, the credit risks of leading firms in an industry are jointly determined, whereby firm-specific shocks can significantly affect the credit risk of peer firms. In addition, the competition-distress feedback affects firms' aggregate risk exposure, which helps explain the gross profitability premium puzzle and the distress anomaly at industry level. Finally, we also provide empirical support for our model's predictions. In particular, we exploit exogenous variations in market structure -- large tariff cuts -- to test the endogenous competition mechanism directly.