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Callable Risky Perpetual Debt: Options, Pricing And Bankruptcy Implications

  • 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)

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    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.

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    File URL: http://hdl.handle.net/11250/163770
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    Paper provided by Department of Business and Management Science, Norwegian School of Economics in its series Discussion Papers with number 2005/22.

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    Length: 33 pages
    Date of creation: 23 Dec 2005
    Date of revision:
    Handle: RePEc:hhs:nhhfms:2005_022
    Contact details of provider: Postal: NHH, Department of Business and Management Science, Helleveien 30, N-5045 Bergen, Norway
    Phone: +47 55 95 92 93
    Fax: +47 55 95 96 50
    Web page: http://www.nhh.no/en/research-faculty/department-of-business-and-management-science.aspx
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