#09-01
Rollover Risks and Market Freezes
Viral Acharya, Douglas Gale and Tanju Yorulmazer, September 2008
For an updated version of this paper, please see #09-32
Abstract: We consider the debt capacity of a risky asset when debt is being rolled over and there is
a liquidation cost in case there is default and the lender seizes the asset. We show that debt
capacity depends on how information reveals itself. When information structure is based
on “optimistic” expectations, no news about the asset is good news; under this structure,
debt capacity does not depend upon rollovers and liquidation cost, and is simply equal to
expected cash flows from the asset. In contrast, when information structure is based on “pessimistic” expectations, no news about the asset is bad news; under this structure, debt
capacity of the asset decreases in the frequency of rollovers and in liquidation cost. In the
limit as the rollovers become unbounded, debt capacity goes to zero even for an arbitrarily
small amount of risk of the asset. Our model explains why markets for rollover debt such
as asset-backed commercial paper experience sudden freezes. The model also provides an
explicit formula for the haircut in borrowing against an asset as a function of its credit risk,
rollover risk and liquidation cost.
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