Leverage, options liabilities, and corporate bond pricing |
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Authors: | Hongming Huang Yildiray Yildirim |
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Institution: | (1) Department of Finance, National Central University, Jhongli City, Taoyuan, 320, Taiwan, ROC;(2) Martin J. Whitman School of Management, Syracuse University, Syracuse, NY 13244, USA |
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Abstract: | The two major problems with typical structural models are the failure to attain a positive credit spread in the very short
term, and overestimation of the overall level of the credit spread. We recognize the presence of option liabilities in a firm’s
capital structure and the effect they have on the firm’s credit spread. Including option liabilities and employing a regime
switching interest rate process to capture the business cycle resolves the above-mentioned drawbacks in explaining credit
spreads. We find that the credit spread overestimation problem in one of the structural models, Collin-Dufresne and Goldstein
(J Finan 56:1929–1957, 2001), can be resolved by combining option liabilities and the regime-switching interest rate process
when dealing with an investment grade bond, whereas with junk bonds, only the regime-switching interest rate process is needed.
We also examine vulnerable option values, debt values, and zero-coupon bond values with different model settings and leverage
ratios.
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Keywords: | Default risk Capital structure Options |
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