Pricing Corporate Debt with Finite Maturity and Chapter 11 Proceedings
15 Pages Posted: 6 Feb 2012 Last revised: 11 Feb 2012
Date Written: January 11, 2011
We are concerned with the valuation of the finite horizon corporate debt under Chapter 11 of the U.S. bankruptcy code. Broadie and Kaya (2007) set up a binomial model by assuming that determining the bankruptcy boundary is restricted to be at initial time. We distinguish the so-called bankruptcy declaring boundary from the bankruptcy boundary, which enables us to develop a continuous-time pricing model by optimal stopping time theory. The resulting free boundary corresponds to the optimal bankruptcy declaring strategy. Since the hybrid feature of finite horizon and optimal stopping time makes analytical pricing formulas unavailable, we propose a numerical procedure based on the associated partial differential equation formulations. Our numerical results reveal that the optimal bankruptcy declaring boundary, usually increasing with time, becomes subtle as time goes to maturity. Also, our model yields higher equity values than Broadie and Kaya's model because the strategy implied by our model is indeed optimal.
Keywords: corporate debt pricing, bankruptcy boundary, declaring boundary, optimal stopping time, chapter 11 bankruptcy code
JEL Classification: G33, G12
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