Leverage, options liabilities, and corporate bond pricing

Hongming Huang, Yildiray Yildirim

Research output: Contribution to journalArticlepeer-review

2 Scopus citations


The two major problems with typical structural models are the failure to attain a positive credit spread in the very short term, and overestimation of the overall level of the credit spread. We recognize the presence of option liabilities in a firm's capital structure and the effect they have on the firm's credit spread. Including option liabilities and employing a regime switching interest rate process to capture the business cycle resolves the above-mentioned drawbacks in explaining credit spreads. We find that the credit spread overestimation problem in one of the structural models, Collin-Dufresne and Goldstein (J Finan 56:1929-1957, 2001), can be resolved by combining option liabilities and the regime-switching interest rate process when dealing with an investment grade bond, whereas with junk bonds, only the regime-switching interest rate process is needed. We also examine vulnerable option values, debt values, and zero-coupon bond values with different model settings and leverage ratios.

Original languageEnglish
Pages (from-to)245-276
Number of pages32
JournalReview of Derivatives Research
Issue number3
StatePublished - Oct 2008


  • Capital structure
  • Default risk
  • Options


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