Leverage, Options Liabilities and Corporate Bond Pricing

by Hueng-Ming Huang of Syracuse University, and
Yildiray Yildirim of Syracuse University

January 10, 2007

Abstract: Most of the existing structural models only focus on the simplified liability structure, and ignore some off-balance sheet liabilities. It has been proved by the collapse of some giant financial companies that the ignorance of off-sheet financing could underestimate default risk and lead to an incorrect credit spread. This paper starts from Collin-Dufresne and Goldstein (2001)'s stationary leverage model and impose option liabilities on the firm's capital structure to resolve the drawbacks of CDG (2001) model, which was pointed out in Eom, Helwege and Huang (2003), in explaining credit spread. In the literature, jump diffusion process for firm value is feasible to increase credit spread (e.g.: Zhou (1997)); regime-switching interest rate process (e.g.: Bansanl and Zhou (2002)) is more fitted to spot rate process, and also reflects the impact of business cycle. Therefore, credit spreads under a jump-diffusion model or a regime-switching interest rate model are also examined in this paper by using simulation-based approach. In this paper, we find that the credit spread overestimation problem in CDG (2001) model can be resolved by combining option liabilities and regime-switching interest rate process when it is an investment grade bond; when it is a junk bond, only regime-switching interest rate process is needed because credit spread is more sensitive to the addition of default boundary, and it easily cause credit spread overshooting. However, the widely used jump-diffusion model is not helpful in resolving the overestimation problem of credit spread. Furthermore, vulnerable option values, debt values, and zero-coupon bond values are also examined under different model settings and leverage ratios in this paper.

Published in: Review of Derivatives Research, Vol. 11, No. 3, (October 2008), pp. 245-276.

Previously titled: Lease Financing, Credit Risk, and the Optimal Capital Structure

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