FIN-00-036
Corporate Bonds: Valuation, Hedging, and Optimal call and Default Policies
February 18, 2000
Viral V. Acharya and Jennifer N. Carpenter
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).
Jennifer Carpenter
Institution: Stern School of Business, New York University
Email: jcarpen0@stern.nyu.edu
Telephone: (212) 998-4233
Viral V. Acharya
Institution: Stern School of Business, New York University
Email: vacharya@stern.nyu.edu
Telephone: (212) 998-0316
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