Effects of Noise on Optimal Exercise Decisions: The Case of Risky Debt Secured by Renewable Lease Income

Posted: 25 Oct 2003

See all articles by Paul D. Childs

Paul D. Childs

University of Kentucky

Steven H. Ott

University of North Carolina (UNC) at Charlotte - Department of Finance & Business Law

Timothy J. Riddiough

University of Wisconsin - School of Business - Department of Real Estate and Urban Land Economics

Abstract

This paper considers the valuation and default exercise policy of risky coupon debt that is secured by a lease-encumbered noisy real asset. For parameter values used in our analysis, asset value noise is shown to reduce the value of waiting to default. Moreover, the borrower is shown to delay default exercise until the noisy signal of asset value is far into-the-money. This latter finding provides an information-based explanation for the apparent under-exercise of the mortgage default option that has been observed in the literature. An implication of this finding is that, if the claimholder recognizes that noise exists, but the empiricist - who is trying to compare observed exercise policy with that predicted by a noiseless model of asset prices - does not, a 'sub-optimal' exercise policy may be inferred when in fact the policy is rational given the information available. This explanation is consistent with evidence from mortgage default studies as to why the observed default exercise boundary is lower than that predicted by standard theoretical option-based models.

Keywords: noise, real options, debt contracting, leases

Suggested Citation

Childs, Paul David and Ott, Steven H. and Riddiough, Timothy J., Effects of Noise on Optimal Exercise Decisions: The Case of Risky Debt Secured by Renewable Lease Income. Available at SSRN: https://ssrn.com/abstract=436921

Paul David Childs (Contact Author)

University of Kentucky ( email )

College of Business & Economics
Lexington, KY 40506-0034
United States
606-257-2490 (Phone)
606-257-9688 (Fax)

Steven H. Ott

University of North Carolina (UNC) at Charlotte - Department of Finance & Business Law ( email )

9201 University City Blvd.
Charlotte, NC 28223
United States
704-687-2744 (Phone)
704-687-6987 (Fax)

Timothy J. Riddiough

University of Wisconsin - School of Business - Department of Real Estate and Urban Land Economics ( email )

School of Business
975 University Avenue
Madison, WI 53706
United States
608-262-3531 (Phone)
608-265-2738 (Fax)

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