Callable Defaultable Bonds: Valuation, Hedging, and Optimal Exercise Boundaries

Posted: 20 Jan 2000

See all articles by Jennifer N. Carpenter

Jennifer N. Carpenter

New York University (NYU) - Department of Finance

Viral V. Acharya

New York University (NYU) - Leonard N. Stern School of Business; New York University (NYU) - Department of Finance; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI); National Bureau of Economic Research (NBER)

Date Written: July 21, 1999

Abstract

This paper models callable defaultable bonds, incorporating both stochastic interest rates and optimal call and default rules. We provide analytical results about valuation and optimal exercise boundaries, which we use to study hedge ratios with respect to Treasury bonds and issuer equity. Since the interest rate and equity risk of a bond depend on how close it is to call or default, the results on optimal exercise boundaries lead to new insights about durations, betas, and hedge ratios. For example, as functions of firm value, bond deltas with respect to the Treasury bond essentially inherit the shape of the exercise boundaries. It follows that a call provision can increase the duration of a defaultable bond and default risk can increase the duration of a callable bond. We also illustrate the difficulty of hedging default risk and quantify the Myers underinvestment problem for typical high grade and junk bond issuers.

JEL Classification: G12, G13, G31, G33

Suggested Citation

Carpenter, Jennifer N. and Acharya, Viral V. and Acharya, Viral V., Callable Defaultable Bonds: Valuation, Hedging, and Optimal Exercise Boundaries (July 21, 1999). Available at SSRN: https://ssrn.com/abstract=172710

Jennifer N. Carpenter (Contact Author)

New York University (NYU) - Department of Finance ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States
212-998-0352 (Phone)
212-995-4233 (Fax)

Viral V. Acharya

New York University (NYU) - Leonard N. Stern School of Business ( email )

44 West 4th Street
Suite 9-160
New York, NY NY 10012
United States
2129980354 (Phone)
2129954256 (Fax)

HOME PAGE: http://www.stern.nyu.edu/~vacharya

New York University (NYU) - Department of Finance ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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