Inconsistent Bond Pricing in a Rational Mark
29 Pages Posted: 12 Oct 2013 Last revised: 5 May 2015
Date Written: April 2015
This study proposes two rational models to reconcile the enigma regarding the inconsistent bond pricing that results among bonds with the same ratings. First, we apply a nonlinear utility function to the expected utility theory and observe different expected utilities for senior bonds and subordinated bonds with the same bond rating. Second, we implement the cumulative prospect theory to demonstrate that the inconsistency occurs when the effect on the convexity of the value function dominates the effect on the overweightness of the weighting function. The two models demonstrate that rather than using the notching policy to explain bond pricing, the inconsistent bond pricing can exist under rational market conditions.
Keywords: Bond pricing; Notching policy; Expected utility theory; Prospect theory; Cumulative prospect theory
JEL Classification: G12, G14
Suggested Citation: Suggested Citation