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An Analytical Model of Bond Risk Differentials

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  • Bierman, Harold
  • Hass, Jerome E.

Abstract

There is broad consensus that three types of risk confront the potential bond purchaser: the risk of default (possible interest and/or principal loss), the risk of interest rate changes (possible principal loss or gain if the bonds are sold before maturity), and price level risk (loss of purchasing power). The analysis in this paper is directed toward the first of these risks, the risk of default. By assuming that investors require interest rate adjustments on debt subject to default sufficient to give them an expected present value equal to the present value associated with the investment of their funds in default-free securities, we examine the process that determines the risk-adjusted equilibrium interest rate and the factors affecting that rate. We also examine the implications of the model for the cost of debt and a firm's debt capacity.

Suggested Citation

  • Bierman, Harold & Hass, Jerome E., 1975. "An Analytical Model of Bond Risk Differentials," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 10(5), pages 757-773, December.
    • Handle: RePEc:cup:jfinqa:v:10:y:1975:i:05:p:757-773_01
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    Cited by:

    1. Mitchener, Kris James & Oosterlinck, Kim & Weidenmier, Marc D. & Haber, Stephen, 2015. "Victory or repudiation? Predicting winners in civil wars using international financial markets," Journal of Banking & Finance, Elsevier, vol. 60(C), pages 310-319.
    2. William J. Crowder & Mark E. Wohar, 1999. "The changing long‐run linkage between yields on Treasury and municipal bonds and the 1986 Tax Act," Review of Financial Economics, John Wiley & Sons, vol. 8(2), pages 101-119, September.
    3. Ewerhart, Christian & Cassola, Nuno & Valla, Natacha, 2010. "Declining valuations and equilibrium bidding in central bank refinancing operations," International Journal of Industrial Organization, Elsevier, vol. 28(1), pages 30-43, January.
    4. Kriz, Kenneth A., 2003. "Comparative costs of negotiated versus competitive bond sales: new evidence from state general obligation bonds," The Quarterly Review of Economics and Finance, Elsevier, vol. 43(2), pages 191-211.
    5. Montmarquette, Claude & Dallaire, Claude, 1980. "Le rendement des obligations provinciales et l’incertitude politique : une analyse de séries chronologiques," L'Actualité Economique, Société Canadienne de Science Economique, vol. 56(3), pages 388-403, juillet-s.
    6. Nippel, Peter, 2016. "Investitionsrechnerische Bewertung von ausfallgefährdeten Krediten," Manuskripte aus den Instituten für Betriebswirtschaftslehre der Universität Kiel 664, Christian-Albrechts-Universität zu Kiel, Institut für Betriebswirtschaftslehre.
    7. Peter P. Rohde & Vijay Mohan & Sinclair Davidson & Chris Berg & Darcy Allen & Gavin K. Brennen & Jason Potts, 2021. "Quantum crypto-economics: Blockchain prediction markets for the evolution of quantum technology," Papers 2102.00659, arXiv.org.
    8. Jeremy Leake, 2003. "Credit spreads on sterling corporate bonds and the term structure of UK interest rates," Bank of England working papers 202, Bank of England.
    9. Wu, Chunchi & Yu, Chih-Hsien, 1996. "Risk aversion and the yield of corporate debt," Journal of Banking & Finance, Elsevier, vol. 20(2), pages 267-281, March.
    10. Cumby, Robert E. & Pastine, Tuvana, 2001. "Emerging market debt: measuring credit quality and examining relative pricing," Journal of International Money and Finance, Elsevier, vol. 20(5), pages 591-609, October.
    11. Blöchlinger, Andreas, 2011. "Arbitrage-free credit pricing using default probabilities and risk sensitivities," Journal of Banking & Finance, Elsevier, vol. 35(2), pages 268-281, February.
    12. Nippel, Peter, 2015. "Eine finanzwirtschaftliche Analyse der Risikovorsorge für erwartete Verluste im Kreditgeschäft," Manuskripte aus den Instituten für Betriebswirtschaftslehre der Universität Kiel 659, Christian-Albrechts-Universität zu Kiel, Institut für Betriebswirtschaftslehre.
    13. Thomas A. Lawler, 1978. "Measuring the default risk of bonds using yields to maturity," Working Paper 78-04, Federal Reserve Bank of Richmond.
    14. Laurence Copeland & Sally-Anne Jones, 2001. "Default probabilities of European sovereign debt: market-based estimates," Applied Economics Letters, Taylor & Francis Journals, vol. 8(5), pages 321-324.
    15. Fernando Alvarez, 1993. "Reserve Requirements: Not a Solution to the Potential Capital Inflow Problem in Cuba," Annual Proceedings, The Association for the Study of the Cuban Economy, vol. 3.
    16. Jess B. Yawitz & Kevin J. Maloney & Louis H. Ederington, 1983. "Taxes, Default Risk, and Yield Spreads," NBER Working Papers 1215, National Bureau of Economic Research, Inc.
    17. Haber, Stephen H & Weidenmier, Marc & Oosterlinck, Kim & Mitchener, Kris, 2014. "Predicting Winners in Civil Wars," CEPR Discussion Papers 10109, C.E.P.R. Discussion Papers.
    18. Louis H. Ederington & Jess B. Yawitz & Brian E. Roberts, 1984. "The Informational Content of Bond Ratings," NBER Working Papers 1323, National Bureau of Economic Research, Inc.
    19. James W. Kolari, 1987. "An Analytical Model Of Risky Yield Curves," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 10(4), pages 295-303, December.
    20. Chunchi Wu, 1991. "A Certainty Equivalent Approach To Municipal Bond Default Risk Estimation," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 14(3), pages 241-247, September.

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