Corporate Bond Valuation and Hedging with Stochastic Interest Rates and Endogenous Bankruptcy

This paper analyzes corporate bond valuation and optimal calland default rules when interest rates and firm value are stochastic.It then uses the results to explain the dynamics of hedging.Bankruptcy rules are important determinants of corporate bondsensitivity to interest rates and firm value. Although endogenousand exogenous bankruptcy models can be calibrated to producethe same prices, they can have very different hedging implications.We show that empirical results on the relation between corporatespreads and Treasury rates provide evidence on duration, andwe find that the endogenous model explains the empirical patternsbetter than do typical exogenous models.