Leverage, Options Liabilities, and Corporate Bond Pricing

37 Pages Posted: 7 Feb 2011

See all articles by Henry Hongren Huang

Henry Hongren Huang

National Central University at Taiwan

Yildiray Yildirim

Zicklin School of Business, Baruch College - The City University of New York

Date Written: February 15, 2008

Abstract

The two major problems with typical structural models are the failure to attain a positive credit spread in the very short term, and overestimation of the overall level of the credit spread. We recognize the presence of option liabilities in a firm’s capital structure and the effect they have on the firm’s credit spread. Including option liabilities and employing a regime switching interest rate process to capture the business cycle resolves the above-mentioned drawbacks in explaining credit spreads. We find that the credit spread overestimation problem in one of the structural model, Collin-Dufresne, Goldstein (2001), can be resolved by combining option liabilities and the regime-switching interest rate process when dealing with an investment grade bond, whereas with junk bonds, only the regime-switching interest rate process is needed. We also examine vulnerable option values, debt values, and zero-coupon bond values with different model settings and leverage ratios.

Suggested Citation

Huang, Henry Hongren and Yildirim, Yildiray, Leverage, Options Liabilities, and Corporate Bond Pricing (February 15, 2008). Review of Derivatives Research, Vol. 11, No. 3, 2008. Available at SSRN: https://ssrn.com/abstract=1755600

Henry Hongren Huang

National Central University at Taiwan ( email )

No. 300, Zhongda Road
Chung-Li Taiwan, 32054
Taiwan

Yildiray Yildirim (Contact Author)

Zicklin School of Business, Baruch College - The City University of New York ( email )

55 Lexington Ave., Box B13-260
New York, NY 10010
United States

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