Winston Wei Dou

Feedback and Contagion through Distressed Competition

Joint with Hui Chen, Hongye Guo, Yan Ji

July 2020

Firms tend to compete aggressively when financially distressed; the intensified competition in turn reduces profit margins, pushing everyone further into distress. To study such feedback and contagion, we incorporate supergames of strategic competition into a dynamic model of long-term defaultable debt, featuring predation, self-defense, and collaboration. Due to the financial contagion, the credit risk of peer firms is interdependent. Industries with higher idiosyncratic-jump risk are more distressed, and they have lower aggregate-risk exposure due to the weaker competition-distress feedback. We provide empirical evidence and exploit exogenous variations in market structure -- large tariff cuts -- to test the core competition mechanism.