Risk Management and Agency Theory: Role of the Put Option in Corporate Bonds

Manish Tewari,Pradipkumar Ramanlal

doi:10.3390/jrfm15020061

Abstract

This study sets out a new methodology to exemplify, through a set of risk metrics called the Greeks, impact of a bond’s structured provisions (e.g., call, put, and conversion options) on its risk characteristics and its propensity for agency conflicts. The methodology is assessed by applying it to a sample of 159 non-convertible bonds, with time-scheduled call and put provisions issued between 1977 and 2005. A structural contingent-claims valuation model is used to value the bonds and estimate the Greeks. The methodology is used to assess the impact of the call and put provisions on the bond’s credit risk and interest-rate risk, as well as the provisions’ ability to mitigate the agency conflict associated with over-investment, under-investment, asset-substitution, and information asymmetry about the firm’s true risk among stakeholders. The main findings of this study are that the put option plays a key role in reducing credit risk, mitigating agency conflict, and protecting against volatility shocks; conversely, the call option plays a key role in reducing interest-rate risk. The methodology is sufficiently general to apply to bonds and preferred stock with any set of structured provisions.

Highlights

This study proposes a new methodology to assess the impact of a bond’s structured provisions on its credit risk, interest-rate risk, and propensity to mitigate agency conflict due to asset-substitution, over-investment, underinvestment, and information asymmetry about the firm’s risk via a set of risk metrics called the Greeks (Delta, Gamma, Vega, and Rho)
The proposition is that the Greeks are a reduced-form representation of the structured provisions that can be used to assess the bond’s risk and agency characteristics
A cross-sectional regression of the pricing errors on the bond’s structured provisions can be expected to explain these errors. Is it sufficient to include the structured provisions as explanatory variables to explain the pricing errors, or do the Greeks contribute towards explaining these errors, recognizing that the Greeks are intended to be a reducedform representation of the structured provisions? The approach taken is to list potential explanatory variables, investigate multicollinearity between the structured provisions and the Greeks to identify redundant variables, and conduct the cross-sectional analysis to identify the role of the Greeks

Summary

Introduction

This study proposes a new methodology to assess the impact of a bond’s structured provisions (e.g., the call, put, and conversion terms) on its credit risk, interest-rate risk, and propensity to mitigate agency conflict due to asset-substitution, over-investment, underinvestment, and information asymmetry about the firm’s risk via a set of risk metrics called the Greeks (Delta, Gamma, Vega, and Rho). The proposition is that the Greeks are a reduced-form representation of the structured provisions that can be used to assess the bond’s risk and agency characteristics. The proposition is simple, yet general, because the Greeks are a standardized set of risk metrics with a standardized interpretation that can be used to assess the bond’s credit risk, interest-rate risk, and its propensity for agency conflict without reference to the original structured provisions. The methodology can be applied to any structured financial security

Methods

Results

Conclusion