Suresh M. Sundaresan

Does Default Risk in Coupons Affect the Valuation of Corporate Bonds?: A Contingent Claims Model

The early work of Black and Scholes, and Merton, made the connection between conventional options and corporate liabilities. The standard textbooks now employ option-pricing arguments in discussing the valuation of stocks, bonds, convertible bonds and warrants; this discussion extends to the various features (such as call and sinking-fund features) that now are appended to these issues. The technique is to recognize that the value of a particular security derives from, or is contingent on, the value of the firm and other economic variables (such as the yield curve for government securities), and then apply the same valuation procedure that one would use to value a call option on some underlying common stock.

Continuous-Time Methods in Finance: A Review and an Assessment

I survey and assess the development of continuous-time methods in finance during the last 30 years. The subperiod 1969 to 1980 saw a dizzying pace of development with seminal ideas in derivatives securities pricing, term structure theory, asset pricing, and optimal consumption and portfolio choices. During the period 1981 to 1999 the theory has been extended and modified to better explain empirical regularities in various subfields of finance. This latter subperiod has seen significant progress in econometric theory, computational and estimation methods to test and implement continuous-time models. Capital market frictions and bargaining issues are being increasingly incorporated in continuous-time theory. THE ROOTS OF MODERN CONTINUOUS-TIME METHODS in finance can be traced back to the seminal contributions of Merton ~1969, 1971, 1973b! in the late 1960s and early 1970s. Merton ~1969! pioneered the use of continuous-time modeling in financial economics by formulating the intertemporal consumption and portfolio choice problem of an investor in a stochastic dynamic programming setting. Merton ~1973b! also showed how such a framework can be used to develop equilibrium asset pricing implications, thereby significantly extending the asset pricing theory to richer dynamic settings and expanding the scope of applications of continuous-time methods to study problems in financial economics. 1 Within a span of about 30 years from the publication of Merton’s inf luential papers, continuous-time methods have become an integral part of financial economics. Indeed, in certain core areas in finance ~such as, e.g., asset pricing, derivatives valuation, term structure theory, and portfolio selection! continuoustime methods have proved to be the most attractive way to conduct research and gain economic intuition. The continuous-time approach in these areas has produced models with a rich variety of testable implications. The econometric theory for testing continuous-time models has made rapid strides in the last decade and has thus kept pace with the impressive progress on the theoretical front. One hopes that the actual empirical investigations and estimation using the new procedures will follow suit soon.

Discriminatory versus uniform treasury auctions: Evidence from when-issued transactions

Abstract We use when-issued transactions data to assess the Treasurys current experiment with uniform auctions. When-issued volume is higher under uniform as compared to discriminatory auctions, suggesting a higher information release, which should reduce pre-auction uncertainty and the winners curse. Under uniform auctions, when-issued volatility falls after the auction and again after the outcome announcement. The pattern is the opposite for discriminatory auctions. This is further evidence that uniform auctions increase pre-auction information and lower the short squeeze. A direct comparison of markups in uniform and discriminatory auctions yields mixed results.

A Comparative Study of Structural Models of Corporate Bond Yields: An Exploratory Investigation

This paper empirically compares a variety of firm-value-based models of contingent claims. We formulate a general model which takes the perpetual coupon bond models of Merton (1974), Leland (1994) and Anderson, Sundaresan and Tychon (1996), as well as some immediate generalizations thereof, as special cases. We estimate these using aggregate time series data for the US corporate bond market, monthly, from August 1970 through December 1996. The data are average yields for industrial corporate bonds rated BBB, Treasury yields, leverage measures derived from the Flow of Funds Accounts, interest coverage measures derived from the National Income Accounts, and volatility measures derived from the stock market. In the basic specification with constant default free rates, we find that models with endogenous bankruptcy barriers (the Leland and the Anderson, Sundaresan and Tychon models) fit quite well. Thus, in these models, variations of leverage and asset volatility are found to account for much of the time-series variations of observed corporate yields. We then use the estimates to calculate the implied probability of default within N years. We find under plausible assumptions on the market risk-premium for levered firms that the models produce default probabilities for 5 years or more which are in line with the historical experience reported by Moodys.

The valuation of floating-rate instruments: Theory and evidence

Abstract A framework for valuing floating-rate notes is developed to examine the effects of (1) lags in the coupon formula, (2) special contractual features and (3) default risk. Evidence from a sample of floaters indicates they sold at significant discounts. While lags in the coupon formulas and other contractual features make these notes more variable, they do not account for the magnitude of the discounts. We conclude that the fixed default premium in the coupon formula of a typical note is inadequate to compensate for time-varying default premiums demanded by investors, who treat other corporate short-term paper as close substitutes.

Bidder Behavior in Multiunit Auctions: Evidence from Swedish Treasury Auctions

We analyze a unique data set on multiunit auctions, which contains the actual demand schedules of the bidders as well as the auction awards in over 400 Swedish Treasury auctions. First, we document that bidders vary their prices, bid dispersion, and the quantity demanded in response to increased uncertainty at the time of bidding. Second, we find that bid shading can be explained by a winner’s curse–driven model in which each bidder submits only one bid, despite the fact that the bidders in our data set use much richer bidding strategies. Third, we explore the extent to which the received theories of multiunit auctions are able to offer insights into the bidder behavior we observe. Our empirical evidence is consistent with some of the predictions of the models of auctions that emphasize private information, the winner’s curse and the champion’s plague. While the models of multiunit auctions serve as useful guideposts, our empirical findings also point to several new areas of research in multiunit auctions that are of policy and theoretical interest.

Strategic analysis of contingent claims

Traditional contingent claims analysis provides an elegant and complete model of the. financing of the dynamic firm but has difficulty fitting the observations in the market. Recent work in corporate finance suggests this is because of its failure to model financial distress realistically. We survey recent efforts to address this issue by deriving valuation formulae from the analysis of non-cooperative equilibria in extensive form games. We illustrate how a simple static bankruptcy model can be incorporated in a dynamic game. We then show how to find the continuous time equivalent of this game. This we use to find closed-form bond formulae in special cases and to exploit efficient numerical techniques generally.

Dynamic Investment, Capital Structure, and Debt Overhang

We develop a dynamic contingent-claim framework to model S. Myers’s idea that a firm is a collection of growth options and assets in place. The firm’s composition between assets in place and growth options evolves endogenously with its investment opportunity set and its financing of growth options, as well as its dynamic leverage and default decisions. The firm trades off tax benefits with the potential financial distress and endogenous debt-overhang costs over its life cycle. Unlike the standard capital structure models of Leland, our model shows that financing and anticipated endogenous default decisions have significant implications of firms’ growth-option exercising decisions and leverage policies. The firm’s ability to use risky debt to borrow against its assets in place and growth options substantially influences its investment strategies and its value. Quantitatively, we find that the firm consistently chooses conservative leverage in line with empirical evidence in order to mitigate the debt-overhang effect on the exercising decisions for future growth options. Finally, we find that debt seniority and debt priority structures have both conceptually important and quantitatively significant implications on growth-option exercising and leverage decisions as different debt structures have very different debt-overhang implications.

An Empirical Analysis of U.S. Treasury Auctions: Implications for Auction and Term Structure Theories

SURESH S U N D A R E S A N is professor offinance and economics at the Graduate School of Business of Columbia University in New York. easury securities have been sold to investors for over five decades using auction mechanisms. Following the infamous May 1991 two-year T Treasury note auction, the Treasury has shifted to the uniform price Dutch auction instead of a multiple price, discriminating auction in certain sectors of the yield curve.’ The Treasury has also announced that it may “reopen” (and boost the supply 04 Treasury issues to prevent squeezes. Indeed, in the five-year and tenyear auctions this year, the Treasury exercised this policy to “relieve the pressure on the financing rates.” As the experiment with the Dutch auction and the new policy measures progresses, we will have more data on how these measures work. For now, we analyze over 1,000 auctions held during 1980-1991 to document some stylized facts. We use collateral-specific rep0 (financing) rates to examine the behavior of current on-the-run Treasury issues. Results show that current Treasury issues become very expensive in the rep0 market as the next auction date approaches. U.S. Treasury auctions differ from art and antiques auctions in major respects. First, Treasury auctions are preceded by forward trading among potential bidders. This forward market, known as the “whenissued” market, is an integral part of the Treasury bidding and distribution system. In other countries, Treasury auctions are also preceded by some form of precommitments by way of when-issued trading. When-issued trading implies that the bidders entering the auction may be bidding with prior short or long positions, which affects their bidding strategies and the auction results. A second difference is the secondary market (the resale market), where participants not only buy and sell

Futures Prices on Yields, Forward Prices, and Implied Forward Prices from Term Structure

When futures contracts are settled with respect to underlying asset prices, received theory suggests that the differences between futures prices and implied forward prices (from the term structure) are strictly due to marking to market, ceteris paribus. Empirical evidence appears to indicate that such differences are small for contracts with short maturities. What happens when the futures contract settles to yields implied by future prices of underlying assets? The Eurodollar futures contract, which is the most actively traded futures contract in the United States, settles to yield as opposed to prices. This unique settlement feature is shown to imply that the implied forward prices from the LIBOR term structure should differ from the futures prices even in the absence of marking to market. Differences due to marking to market effect are small: they are shown to vary between 2 to 45 basis points (less than one-half percent of futures prices). On the other hand, differences between implied forward prices and futures prices are shown to be relatively large.