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Debt Valuation and Marketability Risk

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  • Tychon, Pierre

    (UNIVERSITE CATHOLIQUE DE LOUVAIN, Institut de Recherches Economiques et Sociales (IRES) ; Belgian National Fund for Scientific Research (FNRS))

  • Vannetelbosch, Vincent J.

    (UNIVERSITE CATHOLIQUE DE LOUVAIN, Institut de Recherches Economiques et Sociales (IRES); UNIVERSITE CATHOLIQUE DE LOUVAIN, Center for Operations Research and Econometrics (CORE))

Abstract

This paper studies the valuation of corporate debt contracts in an intertemporal setting under uncertainty taking into account the possibility that the bondholder will be unable to sell his asset. The model considers a coupon paying debt contract with default risk in a binomial setting. Randomly matched investors who place different values upon the firm in bankruptcy bargain for the price of the asset in a secondary market. With this framework we are able to isolate the influence of liquidity risk in the pricing of risky debt contracts. This influence is shown to be function of the heterogeneity of investors' valuations and the range of uncertainty concerning potential bankruptcy costs. In particular, even though mean bankruptcy costs may be relatively low, uncertainty about them can generate relatively large spreads. Furthermore this model is capable of generating a large variety of shapes for the term structure of yield spreads. Finally, the model captures the fact that early after the issue, a bond is relatively liquid and later becomes relatively illiquid depending on the underlying asset value.

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Bibliographic Info

Paper provided by Université catholique de Louvain, Institut de Recherches Economiques et Sociales (IRES) in its series Discussion Papers (IRES - Institut de Recherches Economiques et Sociales) with number 1997020.

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Length: 31
Date of creation: 01 Sep 1997
Date of revision:
Handle: RePEc:ctl:louvir:1997020

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Keywords: Corporate bonds; default risk; bankruptcy; liquidity risk;

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  1. Merton, Robert C., 1973. "On the pricing of corporate debt: the risk structure of interest rates," Working papers 684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  2. Martin J. Osborne & Ariel Rubinstein, 2005. "Bargaining and Markets," Levine's Bibliography 666156000000000515, UCLA Department of Economics.
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Cited by:
  1. Houweling, Patrick & Mentink, Albert & Vorst, Ton, 2005. "Comparing possible proxies of corporate bond liquidity," Journal of Banking & Finance, Elsevier, vol. 29(6), pages 1331-1358, June.

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