Discussion Papers, Department of Finance and Management Science, Norwegian School of Economics (NHH)
No 2005/22:
Callable Risky Perpetual Debt: Options, Pricing And Bankruptcy Implications
Aksel Mjøs ()
and Svein-Arne Persson ()
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.
Keywords: Callable perpetual debt; embedded options; barrier options; optimal bankruptcy; (follow links to similar papers)
JEL-Codes: G13; G32; G33; (follow links to similar papers)
33 pages, December 23, 2005
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