Reduced-Form Valuation of Callable Corporate Bonds: Theory and Evidence

Abstract

We develop a reduced-form approach for valuing callable corporate bonds by characterizing the call probability via an intensity process. Asymmetric information and market frictions justify the existence of a call-arrival intensity from the market's perspective. Our approach both extends the reduced-form model of Duffie and Singleton (1999) for defaultable bonds to callable bonds and captures some important differences between call and default decisions. We also provide one of the first comprehensive empirical analyses of callable bonds using both our model and the more traditional American option approach for valuing callable bonds. Our empirical results show that the reduced-form model fits callable bond prices well and that it outperforms the traditional approach both in- and out-of-sample.