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We examine the relation between capital structure decision and the incentive power of executive compensation that contains both cash and equity components. Our analytical model shows that executive...

For a well-diversified bond portfolio, default risk over the investment horizon is known as the major risk and the risk is largely from correlated defaults. While plenty of theoretical work about d...

In this study, we intend to reveal some problems with the classic valuation method – the weighted average cost of capital (WACC) method. We first address a fundamental question about WACC, that is, should WACC be interpreted as a spot rate, a forward rate or any kind of average of either of them? We show that the nature of WACC is the expected forward rate. We next demonstrate that without understanding this nature, we may misinterpret the famous MM formula and MM Proposition II, as well as develop incorrect valuation framework. Our findings provide insightful implications to academia and practitioners for the proper interpretation and implementation of the WACC method.

We examined the effects of sovereign risk on bond duration in European and Latin American sovereign bond markets over the period 1996 to 2011. We compared the sovereign risk-adjusted duration with the Macaulay duration for both investment- and speculative-grade US dollar-denominated sovereign bonds. We found that the sovereign risk-adjusted duration is significantly shorter than its Macaulay counterpart for all ratings, and the ‘shortening’ effect is stronger for lower rated bonds, which generally intensified during the recent financial crisis. Results are robust when credit default swap (CDS) prices are used as a proxy for changes in sovereign risk. This study provides evidence for advocating the importance of adjusting the bond duration for sovereign risk. More important, this study provides a practical methodology for estimating a sovereign risk-adjusted duration measure for managing international bond portfolios.

This paper examines the effect of sovereign risk on bond duration. We compare the sovereign risk-adjusted duration for U.S. dollar-denominated Asian sovereign bonds with their Macaulay duration for both investment grade bonds and speculative grade bonds. We find that the sovereign risk-adjusted duration is significantly shorter than its Macaulay counterpart for all bonds, regardless of their bond rating and their maturity. Further, the “shortening” effect of sovereign risk on duration gets stronger as bond rating deteriorates and in recessionary conditions. Our findings provide strong support for the importance of adjusting for sovereign risk when bond portfolio managers apply the popular duration measure to hedge interest rate risk.

This paper examines the effects of default risk, call risk, and their interactions on bond duration. We find that call risk decreases durations of default-free bonds, while default risk alone generally decreases durations for risky bonds with only a few exceptions. The joint effect of default and call risk always results in shorter durations for corporate bonds. Controlling for the effect of default risk, call risk has a negative effect on duration, which diminishes as bond ratings decline. Finally, the effect of call risk on duration depends on bond characteristics. Empirical evidence shows that the effect of call risk is smaller for discount bonds and for deep-discount fallen angels.

Using a popular three-factor term structure model that accounts for the correlation between default and interest rates to fit corporate bond yields, we uncover missing factors in the model. The principal component analysis indicates that the model residuals of bonds across different ratings and maturities are driven by some common factors. Further analysis shows that residuals exhibit significant negative correlation with the concurrent and lagged monthly returns of S&P 500. Our results suggest that the term structure model of corporate bonds should incorporate aggregate economic factors in order to better explain the term structure of corporate bond yields.