What Risks Do Corporate Bond Put Features Insure Against?

43 Pages Posted: 16 Mar 2007 Last revised: 16 Oct 2008

See all articles by Jan Ericsson

Jan Ericsson

McGill University; Swedish Institute for Financial Research (SIFR)

Redouane Elkamhi

University of Toronto - Rotman School of Management

Hao Wang

Tsinghua University

Date Written: October 1, 2008

Abstract

Corporate bond prices are known to be influenced by default and term structure risk in addition to non-default risks such as illiquidity. Putable corporate bonds allow investors to sell their holdings back to the issuer and may thus provide insurance against all of these risks. We first document empirically that embedded put option values are related to proxies for all three. In a second step, we develop a valuation model that simultaneously captures default and interest rate risk. We use this model to disentangle the reduction in yield spread enjoyed by putable bonds that can be attributed to each risk. Perhaps surprisingly, the most important reduction is due to mitigated default or spread risk, followed by term structure risk. The reduction in the non-default component is present but rather small.

Keywords: Putable Bonds, Credit Risk, Liquidity Premium, Bivariate Lattice

JEL Classification: G13, G12

Suggested Citation

Ericsson, Jan and Elkamhi, Redouane and Wang, Hao, What Risks Do Corporate Bond Put Features Insure Against? (October 1, 2008). Available at SSRN: https://ssrn.com/abstract=972137 or http://dx.doi.org/10.2139/ssrn.972137

Jan Ericsson (Contact Author)

McGill University ( email )

1001 Sherbrooke St. West
Montreal, Quebec H3A1G5 H3A 2M1
Canada
(514) 398-3186 (Phone)
(514) 398-3876 (Fax)

HOME PAGE: http://people.mcgill.ca/jan.ericsson/

Swedish Institute for Financial Research (SIFR)

Drottninggatan 89
SE-113 59 Stockholm, SE-113 60
Sweden

Redouane Elkamhi

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada

Hao Wang

Tsinghua University ( email )

318 Weilun Building
Tsinghua University
Beijing, 100084
China
86 10 62797482 (Phone)
86 10 62794554 (Fax)

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