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Please use this identifier to cite or link to this item:
http://hdl.handle.net/2451/26787
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| Title: | Corporate Bonds: Valuation, Hedging, and Optimal call and Default Policies |
| Authors: | Acharya, Viral V.
Carpenter, Jennifer N. |
| Issue Date: | 18-Feb-2000 |
| Series/Report no.: | S-CDM-00-08 |
| Abstract: | This paper studies the valuation and risk management of callable,
defaultable bonds when both interest rates and firm value are stochastic
and when the issuer follows optimal call and default policies. Since
interest rate sensitivity is low when call is imminent and firm value
sensitivity is high when default is imminent, characterizing the
issuer's call and default policies is essential to understanding
corporate bond risk management. We develop analytical results on optimal
call and default rules and use them to explain the dynamics of a hedging
strategy for corporate bonds using Treasury bonds and issuer equity. To
clarify the interaction between the issuer's embedded call and default
options, we compare the callable defaultable bond to its pure callable
and pure defaultable counterparts. Each bond's embedded option is a call
on a riskless, noncallable host bond, distinguished only by its strike
price. This generalized call option perspective generates intuition for
a variety of results. For instance, spreads on all bonds, not just
callables, narrow with interest rates; a decline in rates can trigger a
default; a call provision can increase the duration of a risky bond; a
call provision increases equity's sensitivity to firm value, mitigating
the underinvestment problem identified by Myers (1977). |
| URI: | http://hdl.handle.net/2451/26787 |
| Appears in Collections: | Credit & Debt Markets
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