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Leverage, options liabilities, and corporate bond pricing

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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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Authors and Affiliations

  1. Department of Finance, National Central University, Jhongli City, Taoyuan, 320, Taiwan, ROC

    Hongming Huang

  2. Martin J. Whitman School of Management, Syracuse University, Syracuse, NY, 13244, USA

    Yildiray Yildirim

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  1. Hongming Huang
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  2. Yildiray Yildirim
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Correspondence to Yildiray Yildirim.

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Huang, H., Yildirim, Y. Leverage, options liabilities, and corporate bond pricing. Rev Deriv Res 11, 245–276 (2008). https://doi.org/10.1007/s11147-008-9028-8

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