Journal of Finance2014-09-28 4:50 PM


The value of a particular issue of corporate debt depends essentially on three items: (1) the required rate of return on riskless (in terms of default) debt (e.g., government bonds or very high grade corporate bonds); (2) the various provisions and restrictions contained in the indenture (e.g., maturity date, coupon rate, call terms, seniority in the event of default, sinking fund, etc.); (3) the probability that the firm will be unable to satisfy some or all of the indenture requirements (i.e., the probability of default).

While a number of theories and empirical studies has been published on the term structure of interest rates (item 1), there has been no systematic development of a theory for pricing bonds when there is a significant probability of default. The purpose of this paper is to present such a theory which might be called a theory of the risk structure of interest rates. The use of the term “risk” is restricted to the possible gains or losses to bondholders as a result of (unanticipated) changes in the probability of default and does not include the gains or losses inherent to all bonds caused by (unanticipated) changes in interest rates in general. Throughout most of the analysis, a given term structure is assumed and hence, the price differentials among bonds will be solely caused by differences in the probability of default.

In a seminal paper, Black and Scholes [1] present a complete general equilibrium theory of option pricing which is particularly attractive because the final formula is a function of “observable” variables. Therefore, the model is subject to direct empirical tests which they [2] performed with some success. Merton [5] clarified and extended the Black-Scholes model. While options are highly specialized and relatively unimportant financial instruments, both Black and Scholes [1] and Merton [S, 6] recognized that the same basic approach could be applied in developing a pricing theory for corporate liabilities in general.

In Section II of the paper, the basic equation for the pricing of financial instruments is developed along Black-Scholes lines. In Section III, the model is applied to the simplest form of corporate debt, the discount bond where no coupon payments are made, and a formula for computing the risk structure of interest rates is presented. In Section IV, comparative statics are used to develop graphs of the risk structure, and the question of whether the term premium is an adequate measure of the risk of a bond is answered. In Section V, the validity in the presence of bankruptcy of the famous Modigliani-Miller theorem [7] is proven, and the required return on debt as a function of the debt-to-equity ratio is deduced. In Section VI, the analysis is extended to include coupon and callable bonds.

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Journal of Finance

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