A CONTINGENT CLAIMS ANALYSIS OF THE INTEREST-RATE RISK CHARACTERISTICS OF CORPORATE-LIABILITIES

This paper provides a contingent claims analysis of the interest rate risk characteristics of corporate liabilities by identifying Merton's (1973) option pricing model with Vasicek's (1977) mean reverting term structure model. Only a non-zero positive range of duration values for the firms' assets is shown to be consistent with the previous empiric al evidence on the interest rate sensitivity of corporate stocks and b onds. Chance's (1990) duration measure is shown to be biased downward under empirically realistic conditions. Theoretical conditions are der ived under which the duration of a default-prone zero coupon bond can be either higher or lower than the duration of the corresponding defau lt-free bond. The duration of the default-prone bond of a firm with hi gh (low) interest rate sensitive assets is shown to be an increasing ( decreasing) function of the bond's default-risk.