The Option Value of Consumer Bankruptcy

QAU Working Paper No. QAU09-1
by Ethan Cohen-Cole

This paper aims to contribute to the growing literature on the causes of consumer bankruptcy. It presents the consumer bankruptcy decision as an irreversible choice that has an embedded real option value. This allows the use of well known framework for the study of decision making under uncertainty. The principal empirical finding is that cross-sectional variances of economic factors, such as unemployment, are strong predictors of bankruptcy rates and are consistent with the implications of the real options model. This supports anecdotal evidence that individuals are facing increased economic uncertainty and that suggests that uninsurable economic shocks are poorly characterized by local information. Finally, the paper concludes that policy regarding changes in the bankruptcy rate may have been disproportionately focused on credit variables such as utilization rates and supply of credit rather than exposure to risk.

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