A Theoretical Model for the Term Structure of Corporate Credit based on Competitive Advantage

Authors


  • Bala Rajaratnam was supported in part by the National Science Foundation under Grant DMS-1106642. Bala Rajaratnam also gratefully acknowledges Stanford Management Company (SMC) for useful discussions and funding support. The authors are grateful to the anonymous referee and the managing Editor for their deep insights as well as their thoughtful and valuable comments. Correspondence: Myuran Rajaratnam.

Abstract

We derive the term structure of corporate credit based on the competitive advantage of a firm and the tax deductibility of its interest payments. We consider the competitive advantage enjoyed by the firm as the central tenet of our model and capture its eventual demise in a probabilistic manner. We compensate the bond holder for expected losses and then provide an additional spread based on the tax deductibility of interest payments. Our simple intuitive model appears to overcome some of the well-known shortcomings of structural credit risk models.

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