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Leverage, Options Liabilities, and Corporate Bond Pricing

The recent crisis in the subprime loan market has triggered an increase in the default risk of loans and mortgage backed securities, and has emphasized the importance of accurate credit spread estimation. Default risk is generally measured by a credit spread reflecting the additional compensation that an investor requires to accept the risk. In the 1990s, many contingent-claim pricing models were proposed and implemented. As default risk attracts more and more attention, correctly pricing a corporate bond becomes a greater concern for all finance practitioners.

However, the existing models are not rich enough to capture all the risks in corporate bond pricing. Although default risk, liquidity risk, and tax effects have been widely discussed in the fixed-income literature, the capital structure effect and off-balance-sheet instruments are rarely discussed or taken into consideration in corporate bond pricing.

Structural and reduced form models are the primary methods used to model the default process. The primary difference between the two is the amount of information the user has. A structural model requires inside knowledge of the firm’s asset value process, whereas a reduced form model only uses information available to the whole market. The two major problems with typical structural models are the failure to obtain a positive credit spread in the very short term, and incorrect estimation the overall level of the credit spread. Regardless of how healthy a firm may be or how short the maturity of the bond, there is some level below which the credit spread cannot fall. This observation has been empirically supported by Jones, Mason, and Rosenfeld (1984), Sarig and Warga (1989), Fons (1994), and Duffee (1999).

The structural approach has previously focused on modeling the asset process or debt process, and has rarely considered the composition of liabilities. The composition of a firm’s liabilities can be quite diverse and significantly affects the determination of the default boundary and bond prices. For example, firms in the retail industry may use a large amount of lease financing to reduce the financial burden of their fixed costs; firms in the airline industry may lease their aircraft, instead of purchasing. The incentive for using lease financing may vary, but leasing results in significant diversity in the composition of a firm’s liability structure.

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Leverage, Options Liabilities, and Corporate Bond Pricing