Callable Risky Perpetual Debt with Protection Period
28 Pages Posted: 6 Mar 2005 Last revised: 28 Sep 2008
Date Written: December 23, 2005
Issuances in the USD 260 Bn global market of perpetual risky debt are often motivated by capital requirements for financial institutions. We analyze callable risky perpetual debt emphasizing an initial protection ('grace') period before the debt may be called. The total market value of debt including the call option is expressed as a portfolio of perpetual debt and barrier options with a time dependent barrier. We also analyze how an issuer's optimal bankruptcy decision is affected by the existence of the call option by using closed-form approximations. The model quantifies the increased coupon and the decreased initial bankruptcy level caused by the embedded option. Examples indicate that our closed form model produces reasonably precise coupon rates compared to numerical solutions. The credit-spread produced by our model is in a realistic order of magnitude compared to market data.
Keywords: Callable perpetual debt, embedded options, barrier options, optimal bankruptcy
JEL Classification: G13, G32, G33
Suggested Citation: Suggested Citation