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Setting the optimal make-whole call premium

Listed author(s):
  • Eric A. Powers
  • Sudipto Sarkar
Registered author(s):

    With a make-whole call, the call price is calculated as the maximum of the par value and the present value of the bond's remaining payments discounted at the prevailing risk-free rate plus a pre-specified spread known as the make-whole premium. The commonly accepted thumb rule in the investment banking community is to set the make-whole premium at 15% of the at-issue credit spread. Using a standard structural model, we calculate the optimal make-whole call premium, i.e. the make-whole premium that maximizes the ex-ante firm value subject to managers following a second-best call policy that maximizes the ex-post equity value. For reasonable parameterizations, optimal make-whole premiums are relatively close to 15% of the model-generated credit spread. Thus, the 15% thumb rule provides surprisingly good guidance for setting make-whole call premiums.

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    Article provided by Taylor & Francis Journals in its journal Applied Financial Economics.

    Volume (Year): 23 (2013)
    Issue (Month): 6 (March)
    Pages: 461-473

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    Handle: RePEc:taf:apfiec:v:23:y:2013:i:6:p:461-473
    DOI: 10.1080/09603107.2012.727972
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