Alternative Explanations to the Inconsistent Bond Pricing

Abstract

This study proposes two rational models to reconcile the enigma regarding the inconsistent bond pricing that results among bonds with the same ratings. First, we apply a nonlinear utility function to the expected utility theory and observe different expected utilities for senior bonds and subordinated bonds with the same bond rating. Second, we implement the cumulative prospect theory to demonstrate that the inconsistency occurs when the effect on the convexity of the value function dominates the effect on the overweightness of the weighting function. The two models demonstrate that rather than using the notching policy to explain bond pricing, the inconsistent bond pricing can exist under rational market conditions.