Determinants of the Dollar Value of Default Risk: A Put Option Perspective

Determinants of the Dollar Value of Default Risk: A Put Option Perspective This study uses the option valuation framework to identify andinvestigate the factors affecting the cross-sectional difference inindividual corporate bonds' default risk. The dollar value of defaultrisk (DVDR) is measured by subtracting the observed trading price of arisky corporate bond from a Cox-Ingersoll-Ross model value of acorresponding pseudo-default-free bond. From an option pricingperspective, DVDR can be modeled as the value of a put option on thefirm's risky assets. The DVDR of an individual investment-grade corporatebond is hypothesized to be related to the bond rating, time to maturity ofthe bond, size of the issuing firm, volatility of firm value, and dividendyield of the issuing firm. In the case of the first four factors, theempirical results are consistent with the predictions from a put optionperspective. There is a mixed relationship between DVDR and dividendyield, however, which provides a weaker support for the prediction of theoption valuation model. Such a mixed relationship documents the importantrole that dividend payments play in signaling a firm's future earnings andreducing overall agency costs. ["In particular, the formula can be usedto derive the discount that should be applied to a corporate bond becauseof the possibility of default." (Black and Scholes (1973), Journal of Political Economy, Abstract, p. 637.)] http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Review of Quantitative Finance and Accounting Springer Journals

Determinants of the Dollar Value of Default Risk: A Put Option Perspective

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Publisher
Kluwer Academic Publishers
Copyright
Copyright © 2001 by Kluwer Academic Publishers
Subject
Finance; Corporate Finance; Accounting/Auditing; Econometrics; Operation Research/Decision Theory
ISSN
0924-865X
eISSN
1573-7179
D.O.I.
10.1023/A:1011223008379
Publisher site
See Article on Publisher Site

Abstract

This study uses the option valuation framework to identify andinvestigate the factors affecting the cross-sectional difference inindividual corporate bonds' default risk. The dollar value of defaultrisk (DVDR) is measured by subtracting the observed trading price of arisky corporate bond from a Cox-Ingersoll-Ross model value of acorresponding pseudo-default-free bond. From an option pricingperspective, DVDR can be modeled as the value of a put option on thefirm's risky assets. The DVDR of an individual investment-grade corporatebond is hypothesized to be related to the bond rating, time to maturity ofthe bond, size of the issuing firm, volatility of firm value, and dividendyield of the issuing firm. In the case of the first four factors, theempirical results are consistent with the predictions from a put optionperspective. There is a mixed relationship between DVDR and dividendyield, however, which provides a weaker support for the prediction of theoption valuation model. Such a mixed relationship documents the importantrole that dividend payments play in signaling a firm's future earnings andreducing overall agency costs. ["In particular, the formula can be usedto derive the discount that should be applied to a corporate bond becauseof the possibility of default." (Black and Scholes (1973), Journal of Political Economy, Abstract, p. 637.)]

Journal

Review of Quantitative Finance and AccountingSpringer Journals

Published: Oct 3, 2004

References

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