DEFAULT RISK, FIRM CHARACTERISTICS, AND THE VALUATION OF VARIABLE-RATE DEBT INSTRUMENTS

This paper extends the valuation framework developed by Ramaswamy and Sundaresan (1986) to examine the relationship between the risk premium on corporate issues of variable-rate, or floating-rate, debt instrume nts, and the issuer's risk of default. The investor's expected loss on default of any issue is modeled as a call option written on the stoch astic values of future bond payments and the firm's value. Evidence fr om a sample of 154 U.S. corporate floaters issued over the period 1978 to 1998 shows that investors demand significantly lower risk premiums when positive and large correlations between the issuing firm's opera ting cash flows and index interest rates are present. There is also ev idence concerning the existence of some structural differences in risk premiums based on the issuer's industry and the types of indices used . The impact of callability/puttability and several other market and f irm-specific variables are also tested.