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. The existing empirical literature uses a recovery rate process that is misspecified because it includes recovery rates for coupons due after default. Misspecification errors resulting from assuming recovery on all coupons can be substantial in size. They are larger if recovery rates, coupons, maturity and default probabilities are larger. We present evidence that coupon bond market transaction prices reflect the different recovery rates that our model predicts and that our model provides a good fit to market prices.

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

JEL Classification: G12