An Empirical Examination of the Classical Theory of Corporate Security Valuation

This paper tests the main implications of the classical Black-Scholes-Merton theory of corporate security valuation. Data on the debt of companies with a single outstanding bullet bond is used to focus on the cleanest possible application of the theory. The basic Merton model is tested first. Then we offer the first systematic tests of whether observed pricing errors can be mitigated by more complicated models that admit default before maturity, stochastic interest rates and differential recovery rates. The models are tested under a variety of assumed conditions to examine the effects of possible mis-measurement of hard-to-measure parameters. The relatively successful configurations of the Merton model produce mean absolute errors between 80 and 90 basis points. Errors are related to coupon and time to maturity but are not related to credit rating. Evidence on the effect of firm size is equivocal. The Longstaff-Schwartz model's ability to accommodate early default and stochastic risk-free interest rates does not improve prediction accuracy in our sample. Efforts to improve accuracy through use of each firm's industry-average recovery rate were similarly unavailing.

[1]  R. Geske.  The Valuation of Corporate Liabilities as Compound Options , 1977, Journal of Financial and Quantitative Analysis.

[2]  Kenneth D. Garbade,et al.  Managerial Discretion and the Contingent Valuation of Corporate Securities , 1999 .

[3]  L. Fisher.  Contingent Claims Analysis of Corporate Capital Structures: An Empirical Investigation , 1984 .

[4]  Dajiang Guo,et al.  Pricing Risky Debt: An Empirical Comparison of the Longstaff and Schwartz and Merton Models , 1998 .

[5]  I. Welch,et al.  BONDHOLDER LOSSES IN LEVERAGED BUYOUTS , 1993 .

[6]  F. Black,et al.  The Pricing of Options and Corporate Liabilities , 1973, Journal of Political Economy.

[7]  F. Black,et al.  VALUING CORPORATE SECURITIES: SOME EFFECTS OF BOND INDENTURE PROVISIONS , 1976 .

[8]  E. Altman,et al.  Almost Everything You Wanted to Know about Recoveries on Defaulted Bonds , 1996 .

[9]  Oldrich A. Vasicek.  An equilibrium characterization of the term structure , 1977 .

[10]  R. C. Merton,et al.  On the Pricing of Corporate Debt: The Risk Structure of Interest Rates , 1974, World Scientific Reference on Contingent Claims Analysis in Corporate Finance.

[11]  Joseph P. Ogden.  Determinants of the Ratings and Yields on Corporate Bonds: Tests of the Contingent Claims Model , 1987, World Scientific Reference on Contingent Claims Analysis in Corporate Finance.

[12]  Campbell R. Harvey,et al.  An Empirical Comparison of Alternative Models of the Short-Term Interest Rate , 1992 .

[13]  Arthur D. Warga.  Corporate Bond Price Discrepancies in the Dealer and Exchange Markets , 1991 .

[14]  Eduardo S. Schwartz,et al.  A Simple Approach to Valuing Risky Fixed and Floating Rate Debt , 1995 .

[15]  Eric Briys,et al.  Valuing Risky Fixed Rate Debt: An Extension , 1997, Journal of Financial and Quantitative Analysis.

[16]  Arthur D. Warga,et al.  Some Empirical Estimates of the Risk Structure of Interest Rates , 1989, World Scientific Reference on Contingent Claims Analysis in Corporate Finance.