Reduced-Form Valuation of Callable Corporate Bonds: Theory and Evidence

Abstract

We develop a reduced-form approach for valuing callable corporate bonds by characterizing the call probability via an intensity process. Asymmetric information and market frictions justify the existence of a call-arrival intensity from the market's perspective. Our approach extends the reduced-form model of Duffie and Singleton (1999) for defaultable bonds to callable bonds and can capture some important differences between call and default decisions.We also provide one of the first comprehensive empirical analyses of callable bonds using both our approach and the traditional approach of valuing callable bonds as American options. Empirical results show that the reduced-form model fits callable bond price data well and outperforms the traditional approach in both in-sample and out-of-sample applications.

Keywords: Callable bond, reduced-form

JEL Classification: C4,C5,G1