The Valuation of Corporate Coupon Bonds

Abstract

This paper proposes and estimates a tractable, arbitrage-free valuation model for corporate coupon bonds that includes a more realistic recovery rate process. Most existing studies use a recovery rate process that is misspecified because it includes recovery for coupons due after default. Misspecification errors from assuming recovery on all coupons can be substantial; they increase with recovery rates, coupons, maturity, and default probabilities. For a large sample of market transactions: (i) our model has lower pricing errors than one assuming recovery on all coupons, and (ii) the magnitude of our model's outperformance is linked to misspecification errors from assuming recovery on coupons.

Keywords: corporate bonds, default probabilities, credit spreads, recovery rates, illiquidity

JEL Classification: G12