Determinants of the Dollar Value of Default Risk: A Put Option Perspective

This study uses the option valuation framework to identify and investigate the factors affecting the cross-sectional difference in individual corporate bonds' default risk. The dollar value of default risk (DVDR) is measured by subtracting the observed trading price of a risky corporate bond from a Cox-Ingersoll-Ross model value of a corresponding pseudo-default-free bond. From an option pricing perspective, DVDR can be modeled as the value of a put option on the firm's risky assets. The DVDR of an individual investment-grade corporate bond is hypothesized to be related to the bond rating, time to maturity of the bond, size of the issuing firm, volatility of firm value, and dividend yield of the issuing firm. In the case of the first four factors, the empirical results are consistent with the predictions from a put option perspective. There is a mixed relationship between DVDR and dividend yield, however, which provides a weaker support for the prediction of the option valuation model. Such a mixed relationship documents the important role that dividend payments play in signaling a firm's future earnings and reducing overall agency costs. ["In particular, the formula can be used to derive the discount that should be applied to a corporate bond because of the possibility of default." (Black and Scholes (1973), Journal of Political Economy, Abstract, p. 637.)] [PUBLICATION ABSTRACT]