A Contingent Claims Analysis of the Interest Rate Risk Characteristics of Corporate Liabilities

Abstract

This paper provides a contingent claims analysis of the interest rate risk characteristics of corporate liabilities by identifying Merton's (1973) option pricing model with Vasicek's (1977) mean reverting term structure model. Only a non-zero positive range of duration values for the firms' assets is shown to be consistent with the previous empirical evidence on the interest rate sensitivity of corporate stocks and bonds. Chance's (1990) duration measure is shown to be biased downward under empirically realistic conditions. Theoretical conditions are derived under which the duration of a default-prone zero coupon bond can be either higher or lower than the duration of the corresponding default-free bond. The duration of the default-prone bond of a firm with high (low) interest rate sensitive assets is shown to be an increasing (decreasing) function of the bond's default-risk.

Keywords: Interest rate risk, stocks, bonds, duration, Merton, Vasicek

JEL Classification: G1, G10, G12, G13, G21, G32