The impact of competing risks effects on debt contract pricing and efficiency
Peters, Luke Carlton
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This research analyzes the impact of competing risks effects on debt contract pricing and efficiency. The first component of this research examines the effects of call provision design on debt contract efficiency within a frictional contingent claim framework. An option-theoretic approach is employed to value a fully amortizing debt contract in order to measure the expected frictional losses from transaction costs associated with default and call option exercise as a function of debt call structure choice. The model demonstrates the importance of accounting for the competing risk effects between default and call option exercise when choosing an optimal call structure. The essence of the theoretical results is that including a call option within a debt covenant creates ex-post competition between default and call option exercise which may lead to lower expected debt contracting costs ex-ante. The theoretical comparative-static results motivate a rationalization for the patterns of callability and call lockout empirically observed across various forms of corporate and mortgage debt. An empirical analysis of corporate borrowers’ decisions for issuing callable versus noncallable debt provides results that generally support the theoretical construct. The second component of this research analyzes variations over time in callable bond yields, which should reflect, in part, variations in the underlying call option value. Although callable bond yield spreads above Treasury should rise and fall with changing yield curve dynamics such as interest rate volatility and Treasury yield curve slope, the relation should weaken as the bond’s call option value declines. I verify this hypothesis through an empirical analysis of residential mortgage yield spread behavior. I also present empirical evidence based on a mortgage yield spread analysis that a lender’s ex-ante exposure to call risk is a decreasing function of the level of default risk. This result is consistent with the “competing risks” effect between a borrower’s option to call or default on callable debt. The results emphasize the importance of accounting for bond heterogeneity across various parameters when constructing yield spread indices composed of callable bonds.