Review of Derivatives Research

, 11:245

Leverage, options liabilities, and corporate bond pricing

Article

DOI: 10.1007/s11147-008-9028-8

Cite this article as:
Huang, H. & Yildirim, Y. Rev Deriv Res (2008) 11: 245. doi:10.1007/s11147-008-9028-8

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.

Keywords

Default risk Capital structure Options 

JEL Classifications

G13 G33 

Copyright information

© Springer Science+Business Media, LLC 2008

Authors and Affiliations

  1. 1.Department of FinanceNational Central UniversityJhongli City, TaoyuanTaiwan, ROC
  2. 2.Martin J. Whitman School of ManagementSyracuse UniversitySyracuseUSA

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