CORPORATE BONDS - New York University
CORPORATE BONDS
Fall 2000
Corporate Bonds
Spread depends on:
1. Default Premium
2. State Taxes
3. Risk Premium
4. Liquidity
Major Problems
1. Valuation
2. Size of Risk Premium
3. Classification
Valuation
Value = [pic]
where:
1. [pic] is cash flow in [pic] (Promised).
2. [pic] is corporate spot rate.
Why Moodies' grouping might be homogeneous:
Different Default Risk
Gradations
Different rankings across agencies
Different Liquidity
Different Tax Liability
Different Recovery Rates
Bond Age
Model Price = [pic] + adj.
for AA
adj = +.135 (if less than one year) - . 059 (if company rating above bond)
+….
Determining Risk Premium
Basic Idea: If no risk premium, would discount expected cash flow at riskless rate and on average get invoice price. Risk premium is thus extra return so that on average invoice price is correct.
Illustration
Let [pic]be expected cash flow in [pic] then if no risk premium
Model Price = [pic]
where:
[pic] is riskless rate
and Model Price = invoice price on average
Let P be Premium then find P such that
Model Price = Invoice Price
Model Price = [pic]
Note actual estimate
Model Price = [pic]
and
[pic]
Determining Expected Cash Flow
A. Ignoring state taxes
Consider one Period Bond
State Cash Flow
Doesn't Default Principle + Interest
default a * Principle
where a = recovery rate
[pic]
Consider two Period Bond
in one [pic]
in two [pic]
Consider three Period Bond
in one [pic]
in two [pic]
in three [pic]
B. Including state taxes
State taxes are deductable at federal lever. Therefore, effective rate is [pic]
Also note cash flows are changed because of capital loss if bankrupt
Consider One Period Bond
[pic]
tax saving on capital loss
Consider Two Period Bond
in one
[pic]
in two
[pic]
If options use
[pic]
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