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Empirical analysis of a pricing model for corporate bonds with stochastic coupons

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Date
2021
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Abstract
This study empirically investigates the stochastic corporate coupon bond pricing model proposed by Baaquie (2020b) and the pioneering structural risky bond pricing model proposed by Merton (1974). Merton's risky zero-coupon bond pricing model is converted into a portfolio of zeros to study corporate coupon bonds. The seminal work of Merton (1974) is considered as the backbone of corporate bond pricing. Merton's model is based on the generalization of Black and Scholes (1973) option pricing theory. The coupon bond pricing model, proposed by Baaquie (2020b), is based on Merton's bond pricing theory, but coupons are stochastic. Hence, we can call it a stochastic coupon bond pricing model where coupon varies from payment to payment based on the issuer's performance. The proposed model of stochastic coupons has a built-in hedge for the issuer and has the feature of profit and loss sharing between investor and issuer, making it a viable instrument for Islamic finance. The model can be calibrated and tested using market data. This thesis is structured into six chapters, including an introductory chapter, a review chapter, three core chapters, and a concluding chapter. The introductory chapter highlights the motivation, problem statement, and objectives of this study. In review chapter, theoretical and empirical works along with derivation of Merton (1974) and Baaquie (2020b) are reviewed. In conclusion, a summary of the thesis, policy recommendation, limitation, and future directions are discussed. In the third chapter of the thesis, we investigate the following three questions. First, how can one use the proposed model for an empirical study of fixed coupon bonds, since apparently, the model implies stochastic coupons being paid continuously? Second, how the newly introduced parameters, three exogenous parameters - market time and firm's effective valuation and two endogenous parameters - stochastic coupon and firm value volatility, behave for different categories of the bonds and contribute to the improvement of the model's fit? Third, does the stochastic coupon model estimate the bonds' market price more accurately compared to Merton's model? To answer these questions, we have shown how to calibrate and test the stochastic corporate coupon bond pricing model along with newly introduced parameters using a sample of fixed coupon bonds issued by the US corporations. Estimated coupon bond prices from the stochastic model are then compared with the estimated prices from the extended version, portfolio of zeros, of the Merton model.
Keywords
Stochastic corporate coupon , Bond pricing model , Merton model
Citation
Karim, M. M. (2021). Empirical analysis of a pricing model for corporate bonds with stochastic coupons (Doctoral dissertation). INCEIF, Kuala Lumpur. Retrieved from https://ikr.inceif.org/handle/INCEIF/3681
Publisher
INCEIF
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