Inconsistent Bond Pricing in a Rational Mark

29 Pages Posted: 12 Oct 2013 Last revised: 5 May 2015

See all articles by Hong-Yi Chen

Hong-Yi Chen

National Chengchi University - Department of Finance

Hsiao-Yin Chen

Kainan University - Department of Business and Entrepreneurial Management

Date Written: April 2015

Abstract

This study proposes two rational models to reconcile the enigma regarding the inconsistent bond pricing that results among bonds with the same ratings. First, we apply a nonlinear utility function to the expected utility theory and observe different expected utilities for senior bonds and subordinated bonds with the same bond rating. Second, we implement the cumulative prospect theory to demonstrate that the inconsistency occurs when the effect on the convexity of the value function dominates the effect on the overweightness of the weighting function. The two models demonstrate that rather than using the notching policy to explain bond pricing, the inconsistent bond pricing can exist under rational market conditions.

Keywords: Bond pricing; Notching policy; Expected utility theory; Prospect theory; Cumulative prospect theory

JEL Classification: G12, G14

Suggested Citation

Chen, Hong-Yi and Chen, Hsiao-Yin, Inconsistent Bond Pricing in a Rational Mark (April 2015). Review of Pacific Basin Financial Markets and Policies (RPBFMP), Forthcoming, Available at SSRN: https://ssrn.com/abstract=1760527 or http://dx.doi.org/10.2139/ssrn.1760527

Hong-Yi Chen (Contact Author)

National Chengchi University - Department of Finance ( email )

No. 64, Chih-Nan Road
Section 2
Wenshan, Taipei, 11623
Taiwan

Hsiao-Yin Chen

Kainan University - Department of Business and Entrepreneurial Management ( email )

No.1, Kainan Road
Luzhu, Tao Yuan County 33857
Taiwan

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