Strategic Default

From Open Risk Manual

Definition

Strategic Default is the decision by a counterparty (borrower) to default on contractual financial obligations, despite having the ability to fulfill their obligations

The term highlights the fact that a Credit Default is actually an option of the borrower (or the counterparty to a contract that is due a payment)

Rationale

The motivation for strategic default is driven by economic considerations of the consequences of the default event.

  • A major factor in this analysis is the type of lender Recourse to the assets of the borrower.
  • Another major factor are the longer term reputation implications of a default to the agents involved (and for example the implications to future access to credit)

Issues and Challenges

It is generally assumed (and even expected) that commercial counterparties will exercise their default option in economically optimal terms. For physical persons there is instead a broader discussion about the behavioural and moral aspects (see e.g. [Wikipedia Entry]). Sub-optimal exercise of financial options by individuals is also relevant in the context of Prepayment Risk