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Callable Risky Perpetual Debt: Options, Pricing And Bankruptcy Implications

Author

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  • Mjøs, Aksel

    () (Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration)

  • Persson, Svein-Arne

    () (Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration)

Abstract

Issuances of perpetual risky debt are often motivated by capital requirements for financial institutions. However, observed market practice indicates that actual maturity equals first possible call date. We analyze callable risky perpetual debt including an initial protection period before the debt may be called. To this end we develop European barrier option pricing formulas in a Black and Cox (1976) environment. The total market value of debt including the call option is expressed as a portfolio of barrier options and perpetual debt with a time dependent barrier. We analyze how the issuer’s optimal bankruptcy decision is affected by the existence of the call option using closed-form approximations. In accordance with intuition, our model quantifies the increased coupon and the decreased bankruptcy level caused by the embedded option. We show that the option will be exercised even at fairly low asset levels at the time of expiry.

Suggested Citation

  • Mjøs, Aksel & Persson, Svein-Arne, 2005. "Callable Risky Perpetual Debt: Options, Pricing And Bankruptcy Implications," Discussion Papers 2005/22, Norwegian School of Economics, Department of Business and Management Science.
  • Handle: RePEc:hhs:nhhfms:2005_022
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    File URL: http://hdl.handle.net/11250/163770
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    Keywords

    Callable perpetual debt; embedded options; barrier options; optimal bankruptcy;

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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