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Default Risk and the Effective Duration of Bonds

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  • David F. Babbel
  • Craig Merrill
  • William Panning

Abstract

Default risk creates difficulties for fixed-income portfolio managers in measuring a portfolio's exposure to interest rate risk. It also heightens the anxiety of traders and arbitragers who are hedging their investments, and it compounds financial institutions' problem of matching assets and liabilities. The consensus among researchers is that credit risk shortens the effective duration of corporate bonds. This paper provides estimates of how much shorter durations become because of credit risk. These estimates are based on observable data and easily estimated bond pricing parameters. Because the duration measures are taken with respect to movements in a common reference rate of interest, they can be used with greater confidence than can other measures when attempting to compute the duration of a portfolio of bonds subject to varying degrees of credit risk.

Suggested Citation

  • David F. Babbel & Craig Merrill & William Panning, 1997. "Default Risk and the Effective Duration of Bonds," Financial Analysts Journal, Taylor & Francis Journals, vol. 53(1), pages 35-44, January.
    • Handle: RePEc:taf:ufajxx:v:53:y:1997:i:1:p:35-44
    DOI: 10.2469/faj.v53.n1.2054
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    References listed on IDEAS

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    1. Khang, Chulsoon, 1979. "Bond Immunization When Short-Term Interest Rates Fluctuate More Than Long-Term Rates," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 14(5), pages 1085-1090, December.
    2. Robert A. Jarrow & Stuart M. Turnbull, 2008. "Pricing Derivatives on Financial Securities Subject to Credit Risk," World Scientific Book Chapters, in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 17, pages 377-409, World Scientific Publishing Co. Pte. Ltd..
    3. Geske, Robert, 1977. "The Valuation of Corporate Liabilities as Compound Options," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 12(4), pages 541-552, November.
    4. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
    5. Hayne Leland, 2019. "Bond Prices, Yield Spreads, and Optimal Capital Structure with Default Risk," Finance, Presses universitaires de Grenoble, vol. 40(3), pages 45-75.
    6. Fons, Jerome S, 1987. "The Default Premium and Corporate Bond Experience," Journal of Finance, American Finance Association, vol. 42(1), pages 81-97, March.
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    Cited by:

    1. Babbel, David F. & Merrill, Craig B. & Meyer, Mark F. & de Villiers, Meiring, 2004. "The Effect of Transaction Size on Off-the-Run Treasury Prices," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 39(3), pages 595-611, September.
    2. Scott D. Aguais & Anthony M. Santomero, 1997. "Incorporating New Fixed Income Approaches into Commercial Loan Valuation," Center for Financial Institutions Working Papers 98-06, Wharton School Center for Financial Institutions, University of Pennsylvania.
    3. Díaz, Antonio & Escribano, Ana, 2017. "Liquidity measures throughout the lifetime of the U.S. Treasury bond," Journal of Financial Markets, Elsevier, vol. 33(C), pages 42-74.
    4. David F. Babbel & Anthony M. Santomero, 1997. "Risk Management by Insurers: An Analysis of the Process," Center for Financial Institutions Working Papers 96-16, Wharton School Center for Financial Institutions, University of Pennsylvania.
    5. Kraft, Holger & Munk, Claus, 2007. "Bond durations: Corporates vs. Treasuries," Journal of Banking & Finance, Elsevier, vol. 31(12), pages 3720-3741, December.
    6. Sarkar, Sudipto & Hong, Gwangheon, 2004. "Effective duration of callable corporate bonds: Theory and evidence," Journal of Banking & Finance, Elsevier, vol. 28(3), pages 499-521, March.
    7. Jacoby, Gady & Roberts, Gordon S., 2003. "Default- and call-adjusted duration for corporate bonds," Journal of Banking & Finance, Elsevier, vol. 27(12), pages 2297-2321, December.
    8. Francisco Sotos, 2003. "Interest risk and default risk: A conditional volatility study," International Advances in Economic Research, Springer;International Atlantic Economic Society, vol. 9(1), pages 56-63, February.

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