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Inconsistent Bond Pricing in a Rational Market

Author

Listed:
  • Hong-Yi Chen

    (Department of Finance, National Chengchi University, No. 64, Sec. 2, Zhinan Rd., Taipei, Taiwan)

  • Hsiao-Yin Chen

    (Department of Business and Entrepreneurial Management, Kainan University, No. 1, Kainan Rd., Luzhu District, Taoyuan City, Taiwan)

Abstract

This study proposes two rational models to reconcile the enigma regarding the inconsistent bond pricing that results among bonds with the same ratings. First, we apply a nonlinear utility function to the expected utility theory and observe different expected utilities for senior bonds and subordinated bonds with the same bond rating. Second, we implement the cumulative prospect theory to demonstrate that the inconsistency occurs when the effect on the convexity of the value function dominates the effect on the overweightness of the weighting function. The two models demonstrate that rather than using the notching policy to explain bond pricing, the inconsistent bond pricing can exist under rational market conditions.

Suggested Citation

  • Hong-Yi Chen & Hsiao-Yin Chen, 2016. "Inconsistent Bond Pricing in a Rational Market," Review of Pacific Basin Financial Markets and Policies (RPBFMP), World Scientific Publishing Co. Pte. Ltd., vol. 19(03), pages 1-17, September.
    • Handle: RePEc:wsi:rpbfmp:v:19:y:2016:i:03:n:s021909151650017x
    DOI: 10.1142/S021909151650017X
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    References listed on IDEAS

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