Inflation, Bankruptcy, Default Premia and the Stock Market

In this paper, we explore some of the possibilities, and argue that in the absence of index-linked loans, higher inflation implies higher liquidation rates and default premia. This would also be one possible reason why higher inflation would depress share values. Our evidence also suggests that the Modigliani and Cohn (1979) 'valuation errors hypothesis' is extremely important. In order to see why higher inflation might lead to more bankruptcies, consider the following example. Suppose that the real interest rate, p, is i %, and that a firm has borrowed ?iooo. If there is no inflation, the firm's interest payments are ?io. Now, suppose that inflation (p) rises to IO %, and that the nominal interest rate (r) is given by the formula, (i + r) = (i + p) (i +fi). Then, r rises to I I -I %, and total interest payments to ?i i i. Hence, at a time when revenue has risen by only IO %, interest payments rise elevenfold, and this creates cashflow problems for the firm. Index-linked debt would avoid this problem because the principal could be indexed, and would rise to ?i ioo, leaving the firm to only pay Li i in interest