Journal of Financtal Economics 10 (1982) 375-406 North-Holland Pubhshmg Company

BOND INDENTURE PROVISIONS AND THE RISK

OF CORPORATE DEBT*

Thomas S.Y. HO
New York Umverslty, New York, NY 10006, USA

Ronald F. SINGER
Vmverslty ofHouston, Houston, TX 77004, USA

Received September 1980, revtsed verston received September 1982

This paper exammes the effect of alternative bond indenture provrslons on the allocation of risk
among the firms clatmants. The approach taken here differs from that of earlier studies m that
risk allocation 1s examined while the firms leverage (m market value terms) is held constant In
this context, four indenture provrsrons are examined (1) the time to maturity, (2) the promised
payment schedule, (3) financing restrictions and (4) priority rules. It 1s concluded that nsk is
transferred from stockholders to bondholders as the time to maturity and promised payment
increase appropriately. Furthermore substitution of longer-term debt for an equal amount of
shorter-term debt also increases the nsk to bondholders while decreasing the nsk to
stockholders The analysis shows that a coupon bond can be represented by a unique discount
bond wrth the same nsk and value. This permits the charactenzatlon of the effective maturity of
a risky debt issue, a concept analogous to the stochastic duration of a default-free coupon bond.
These results are shown to be independent of the means used to finance the debt issue. Fmally,
it 1s concluded that the relative risk associated with different bonds issued by the same firm
cannot be determined by the structure of priority rules alone It 1s also necessary to consider the
timing of the promised payments compared to that of the other debt Issues m the firms capital
structure

1. Introduction

Since the seminal work of Modighani and Miller (1958) capital structure
theorists have concentrated on the impact of leverage on the allocation of
risk between bondholders and stockholders. These investigations (often
implicitly) impose an arbitrary set of indenture provisions, and concentrate
on the risk of the debt and equity claims as the market value of the debt
changes. On the other hand, mvestigations explicitly dealing with the effect
of alternative indenture provisions typically utilize a comparative statics

*The authors wish to thank Michael Jensen, Avner Kalay, Clifford Smith, Jr. and the referee
for then helpful comments.
In a perfect market setting, Hamada (1972), Rubmstem (1973) and Chen (1978), have
considered these issues

0304405X/82/000Cr0000/$02.75 0 1982 North-Holland

376 TS Y Ho and RF. Smger, Bond mdentures and rwk

approach.2 This framework fails to distinguish between the impact on risk

resulting:
(1) directly from changes in the timing and conditions of payments to
bondholders and stockholders,
(ii) mdirectly from changes in the firms leverage.
This p,rper focuses on(i) in isolation from (ii). That is, the study considers the
allocation of risk among the firms claimants, for alternative bond indenture
provisions, while holding leverage unchanged.3
In this context four indenture provisions are considered. They are (1)
maturity, (2) the promised payment schedule, (3) financing restrictions, and
(4) priority rules. The major results are summarized below.
The paper first investigates the relationship between the time to maturity
and the risk of a discount bond. As the bonds time to maturity changes, its
promised payment is adjusted so that the market value of the debt is held
constant. Theorem 1 shows that this results in a positive relationship
between risk and maturity. This verities .Yawitzs (1978) conjecture that the
phenomenon of decreasing risk as maturity increases [as found by Chen
(1978), Galai and Masulis (1976) and Merton (1974)] is due solely to the
reduced leverage associated with the longer time to maturity.
The paper then extends the analysis to study the impact of changes in the
promised payment schedule of a bond (package) with multiple promised
payments. Theorem 2 shows that replacing longer-term debt with shorter-
term debt of the same value decreases the risk of the total debt. Theorem 3
concludes that the magnitude of this increase depends on the initial payment
schedule. Furthermore, Theorem 4 demonstrated that a debt package of
more than one maturity can be characterized by a unique discount bond
having the same market value and risk as the original debt package. The
time to maturity of this bond is a measure of effective maturity discussed in
Weinstein (1981). This maturity is the risky bond analogue to the stochastic
duration of a default-free bond as defined in Cox, Ingersoll and Ross (1979).
The impact of alternative financing restrictions is then considered. The
relationship between risk and the promised payment schedule is analyzed
when the firm finances these payments externally (by junior issues) or
internally. Although the means of financing affects the allocation of risk
2These mvestrgations typically employ a contingent claims pricing model to value various
indenture provrsions. Merton (1974) values a pure discount bond subject to default risk Black
and Cox (1976) extend the analysis to evaluate the effect of priority rules and safety covenants
on the pricing of risky debt. Geske (1977) derives a compound option model to value risky
coupon debt and debt of different maturities within the capital structure of a single firm
Ingersoll (1977) values convertible debt and Ho and Singer (1982) consider the valuation of
sinking fund provisions Smith and Warner (1979) and Myers (1977) consider the implications of
alternative indenture provrsions when there exists agency costs
3Throughout the paper nsk is defined as the elasticity of the value of the debt wtth respect to
the value of the firm.
 TS.Y Ho and RF Smger, Bond mdentures and risk 371

among the claimants, Theorem 5 confirms all of the results in Theorems 2, 3

and 4 under this financing rule.
Finally, the paper investigates the effect of alternative priority rules on the
allocation of risk among the individual issues within a debt package. When
short-term debt IS senior to long-term debt, the junior debt is always riskier
than the senior debt. However, when senior debt is of a longer maturity than
the junior debt, the results are more complicated. For example, with a
relatively large amount of long-term debt and small amount of short-term
debt the senior long-term debt issue can be riskier than the junior short-term
debt. This is because the junior short-term debt will almost certainly be paid
in full, while there is a high probability that the long-term promised payment
will not. This Junior debt may m fact be less risky than the firms senior debt.
The paper is organized in the following format. Section 2 presents the
market assumptions retained throughout the paper. Section 3 analyzes the
risk and maturity relationship of a discount bond. Section 4 examines the
effects of the promised payments schedule of a bond package. The effect of
restrictions on the means by which bond payments can be financed are
considered in section 5. Priority rules are examined in section 6. Finally, the
results are summarized and related to empirical regularities in section 7.

2. The basic assumptions

This paper examines the effects of bond indenture provisions on the risk of
a firms debt. The value and behavior of the debt is described using
contingent claims pricmg theory. Throughout the paper, risk refers to the
elasticity (of the value of the bond with respect to the value of the firm) and
is given by

Y= (dD/d V(I/lD),

where I/ is the market value of the firm and D is the market value of the
debt. Merton (1973) shows that this is an appropriate measure of risk, in the
Rothschild-Stiglitz (1970) sense for contingent claims models.4

The analysis employs the following market assumptions [these are

standard assumptions in contingent claims models of corporate debt; see, for
example, Merton (1974)]:

(A.l) There are no taxes, transaction costs or other frictions, so that the
value of the firm is independent of its capital structure [Modigliani and
Miller (1958)].

41n a portfoho context, an assets beta is an appropriate measure of risk Galai and Masuhs
(1976) show that bD= V/J, where Pn 1s the debts beta and /Iv 1s the firms beta Therefore, a
bonds elastlclty is a measure of risk relative to the risk of the firm
378 TS Y Ho and RF Smger, Bond indentures and rwk

(A.2) The instantaneous riskless rate of interest, r, is constant and known

with certainty throughout the relevant horizon.
(A.3) The firm makes no dividend payments or other disbursements to its
stockholders.
(A.4) The value of the firm V is perceived, by all market participants, to
follow an Ito process such that

dV/V=crdt+odw,

where a is the constant instantaneous drift coefficient, B is the constant

instantaneous standard deviation, and dw is the standardized Wiener
process.
(AS) Default occurs if any of the indenture provisions are violated. In
default all claims on the firm are (costlessly) transferred to
bondholders.5 These claims are distributed among the bondholders by
well defined priority rules.

3. Maturity the risk a discount

This section the risk discount bonds different maturities.

a given a discount is completely by the of the
payment F, the maturity of the bond r, and the assumptions
enumerated in section 2. Holding the promised payment constant, the market
value of a discount bond is lower the longer the time to maturity. Thus to
consider the risk of bonds of equal value, but with different maturities, it is
necessary to adjust the promised payment appropriately. If this is done the
impact of maturity on bond risk is determined by the tradeoff among three
factors affecting the bonds risk:

(1) The increased promised payment raises the maximum value of the firm
at which it defaults.
(2) The longer maturity increases the expected value of the firm at maturity.
(3) The longer the maturity the greater the variance of the value of the firm
at maturity.
This section considers the net impact of these effects.

Default can be remedied either by amendmg the contract, or by fihng for bankruptcy
Bankruptcy IS a legal process, which IS concluded either by reorganization or hqmdatlon [see
Smith and Warner (1979)]
 TS Y Ho and RF Smgdr, Bond mdentures and rusk 379

3.1. The model

Assumptions (A.l)-(AS) permit treating the debt as a contingent claim on
the value of the firm. In addition to these assumsptions, the bond is
described as follows:
(A.6) The firms capital structure consists of equity and a single discount
bond with promised payment F at maturity z.
In this context, Merton (1974) expresses the value of the debt, D and its
elasticity y as

D=VN(z-o&)+Fe-N(-z), (34
and

(3.2)

where

(3.3)

is the bankruptcy state,

N(x)= j f(s)ds
-CX

is the standard normal probability distribution, and

f(x) =(1/J%) e-@

is the standard normal density. Note that N(z) is the risk-neutral probability
of default. Theorem 1 describes the relationship between the debts elasticity
and its time to maturity.

Theorem 1. The relationship between the elasticity of a discount bond and its
maturity, when its pormised payment is adjusted to hold the market value of the
bond constant, is as follows:
(i) The elastictty is an increasing function of time to maturity.
(ii) The elasticity approaches one as time to maturity goes to infinity; it
approaches zero as the time to maturity gets arbitrarily small.

Proof It is necessary to examine the relationship between elasticity and

380 T.S I: Ho and RF Smger, Bond indentures and nsk

time to maturity holding the market value of the debt unchanged. When
maturity changes, the debts promised payment must be adjusted to assure a
constant debt value. That is, eq. (3.4) must hold:

(3.4)

By direct calculation of aD/aJz and aD/dF (note that aD/az

=O),(3.4) is
expressed as

-~f(z-~&)Vd&2F~N(-z)e-r&d&+N(-z)e-dF=0. (3.5)

Furthermore, dz, dF and dJ z are related by the bankruptcy conditron (3.3).

Differentiating (3.3) with respect to F and J% gives this relationship as

eJ;-f~*j,-(a&dz + zad&--a&d&)=e-dF-Fre-2fid.&.

(3.6)
Eqs. (3.5) and (3.6) can be used to eliminate dF; and simplifying gives the
relationship between dz and d& as

dz= --(). (3.7)

N-4

Note that dz/dfi>O, since f(z)/N( -z) >z [Kendall and Stuart (1977, p.
159)]. That is, given the market value of the debt, the probability of default is
positively related to maturity.
Finally, eq. (3.2) relates the elasticity explicitly with z and r. Differentiating
(3.2) gives

dy = (V/D)f(z
- o&)(dz - crd&). (3.8)

Notice that the leverage ratio (D/V)is constant by the design of the problem.
Using eqs. (3.7) and (3.Q dz can be eliminated and it follows that

(3.9)

Part (i) of the theorem follows immediately from (3.9). Since f(z)/N( -z)>z
for all values of z, dq/dz > 0 for any value of z, z and D/E
 TS Y Ho and R.F Smger, Bond mdentures and ruk 381

Part (ii) requires that hm,,, y = 1 and lim,,, q =O. The proof first
establishes the relationship between z and r.
From the bond valuation equation, eq. (3.1),

ao/az=~f(z-oJz)-Fe-*f(-z)=O,
so that

F is then eliminated, and (3.1) rearranged to give

(D/i+N(z-CT&) N(-z)
(3.10)
f(z-o&l =f(z>-
Eq. (3.10) relates z and z. Therefore it gives the asymptotic behavior of z as r
goes to infinity so that lim,,, r] can be examined. Appendix A shows that as
z-+00, (z-c& z converges to a value x,, such that N(x,) = O/l/: Since

the result follows.

Next, it has to be shown that lim,,ao y = 0. Note that from eq. (3.7) z
decreases with Z, and from eq. (3.10) z does not take on any timte value for
r =O. Hence it follows that lim-c-tm~= - co. The result then follows trivially
from eq. (3.2). Q.E.D.

It is instructive at this point to relate these results to the existing literature.

Part (i) of the theorem contrasts with previous studies where Merton (1974)
Galai and Masulis (1976) and Chen (1978) conclude that a change in
maturity can either increase or decrease bond risk. Merton, representative of
these results, concludes that: Contrary to what many might believe, the
relative riskiness (elasticity) of the debt can decline as. ..the time until
maturity increases. . . . This is the case if d > 1 (d is Mertons quasi-debt to
firm value ratio Fe-rz/V).6 Merton explains his result by arguing that
when the time to maturity is short, a firm with a quasi-debt to firm value
ratio greater than one will have a high probability of default. Increasing the
time to maturity improves the chances that firm value will increase enough
to meet the promised payment. Thus the equity component and pari passu the
elasticity of the debt declines with maturity. For quasi-debt to firm value

6Merton (1974, p. 464).

382 TS E: Ho and RF Smger, Bond mdentures and risk

ratios less than one, the argument goes the other way and elasticity increases
with maturity.
In their derivations Merton holds quasi-debt constant and Galai and
Masulis and Chen hold the promised payment constant. As a result an
increase in maturity reduces the market value of the debt. In contrast,
Theorem 1 holds the market value of the debt constant, implying an increase
in quasi-debt (that is as maturity increases, the offsetting promised payment
is increased at a rate exceeding the riskless rate of interest). Note that for
short maturities when the market valued leverage ratio is low, the debt will
be close to riskless so that quasi-debt approximates its market value. In this
case, Mertons result is consistent with Theorem 1. However, as the time to
maturity lengthens the debt becomes risky. It follows that bond elasticity
increases faster when the market value of the debt is held constant since
quasi-debt must increase. Furthermore, Theorem 1 shows that bond elasticity
is always an increasing function of maturity. For high leverage ratios, the
rate of increase in the promised payment exceeds the riskless rate. This
increase in quasi-debt more than offsets the risk reduction that would occur
if quasi-debt (or promised payment) were held constant.
Part (ii) of the theorem shows that the debt, at all leverage ratios, becomes
riskless (n+O) as the time to maturity gets arbitrarily small and approximates
unlevered equity (q+l) as the time to maturity tends to inlimty. This can be
explained by examining the behavior of the promised payment as maturity
goes to these limits. As a contingent claim, the market value of the debt is
always less than the value of the firm. Furthermore, as the time to maturity
gets small, the promised payment converges to the given market value. Thus
for a maturity arbitrarily close to zero, the promised payment must be less
than the value of the firm and will surely be paid. On the other hand, as time
to maturity increases, so must the promised payment. The equity component
of the debt increases, so that it behaves more like unlevered equity.
For a given leverage ratio, a change of debt maturity effects a change in
risk allocation between bondholders and stockholders. Theorem 1 focuses on
the risk to bondholders, and the following corollary describes the risk to the
stockholders:

Corollary. The elasticity of the equity, qE, in a firm with a single discount
bond behaves as follows:

(i) qE is a decreasing function of time to maturity of the bond, when the

market value of the debt is held constant.

(ii) qE tends to one as time to maturity goes to infinity. qE tends to 1 + DIE as

time to maturity goes to zero, where DIE is the r@io of the market value of
the debt to that of equity.
 TS Y Ho and RF Smger, Bond mdentures and ruk 383

ProoJ: By the definition of the respective elasticities, and given the

Modigliani-Miller assumptions, the weighted average of the elasticities is
one. That is,

where E is the market value of the equity. It follows that

Since D/V is a constant, the corollary follows. Q.E.D.

Fig. 1 summarizes the results of Theorem 1 and its corollary. Notice that
as maturity goes to zero, the debt becomes riskless and the equitys elasticity
tends to 1 +D/E. This expression is thei familiar leveraging effect associated

Elasticity

oo Time to Maturity 1Z)

Fig. 1 The elasticity of debt and the elasticity of equity as functions of the discount bonds
maturity (7) It IS assumed that the firms capital structure consists of eqmty and a discount
bond, and that the debt to eqmty ratlo (D/E) IS held constant
384 lXY Ho and R.F Smger, Bond mdentures and risk

with riskless debt [Hamada (1972), Rubinstein (1973)].7 As time to maturity

increases, risk is transferred from equity to debt. Finally in the limit, both the
equity and the debt behave as unlevered equity (y =qE = 1). Note that for
infinite maturity, the risk of the equity is the same when either the debts
promised payment or market value is held constant. However, the reasons
for this result are quite different. As maturity increases while holding
promised payment constant the firms (market) leverage ratio declines. In the
limit the debt is valueless so that equity behaves as if it were unlevered. It is
somewhat surprising to find that this result also holds when leverage is kept
constant. Even though equity may be highly levered, it behaves as if it ,were
almost unlevered when debt maturity is sufficiently long,
It has been traditional to discuss the component risk of debt and equity
m terms of market leverage ratios. Implicit in the analysis is a given debt
maturity. But the allocation of risk between bondholders and stockholders is
determined by both debt maturity and leverage.
Fig. 2 depicts the risk of equity and debt in a firm having a single discount
bond, for different debt maturities and debt equity ratios. The height of
surface DDD represents the debts elasticity. The surface mcreases with both
the debt-equity ratio and the time to maturity. It intersects both horizontal
axes so that as the time to maturity or the debt-equity ratio approaches
zero, the debt becomes riskless. The horizontal surface EFG represents the
standardized risk of the firm and takes on the value one at all points.
Finally, the surface EEE represents the equitys elasticity.- This surface
increases with the debt-equity ratio, and decreases with the time to maturity
of the debt. It is higher than the EFG plane for all positive values of the
debt-equity ratio and the time to maturity. Finally, it intersects the EFG
plane (takes on a value of 1) along the time to maturity axis, representing
unlevered equity (the debt-equity ratio is zero along this axis).
Notice that when the time to maturity is zero, the debt is riskless. Equitys
elasticity is described by the straight line QE and is equal to (1 + D/E). This
is the classical leverage effect of riskless debt as described by Modigliani and
Miller (1958) and Rubinstein (1973). The intersection of the three surfaces on
the plane DPEE represents the component risk of debt and equity for a
given time to maturity. The curve EE represents the risk of equity, and the
curve DD represents the risk of the debt as functions of leverage. This is
consistent with the results of Merton (1974) and Hamada (1972). Finally, the
curves on the surface PDEE represents the allocation of risk for a given
debt-equity ratio as the time to maturity of the debt increases. These curves
are represented in fig. 1 above.

7Both Hamada (1972) and Rubmstem (1973) consider equity risk m the context of a smgle-
period Capital Asset Pricmg Model. Hamada (1972) investigates the risk of eqmty m the
presence of risky debt, whereas Rubmstem (1973) considers the case of nskless debt In both
papers, beta 1s used as the measure of risk
 T.S.Y; Ho and R.F Smger, Bond

Elasticity

Fig. 2. The elasttcrty of debt and the elasticity of equity as functions of the time to maturtty (z)
and the debt to equity ratio (D/E). It is assumed that the firms capital structure consists of
eqmty and a discount bond The surface QEEE represents the elasticity of equity, and the
surface DDD represents the elasticity of debt. The plane EFG represents an elasticity of unity

This section provides some insight into the concept of the crisis at maturity
as discussed in Johnson (1967). It is argued that the probability of default is
greatest at maturity, so that low-grade debt becomes riskier as the time to
maturity increases. This argument applies to an existing bond (with a given
promised payment) as the time to maturity approaches. Theorem 1 and its
corollary indicate that this argument cannot be used when considering the
risk of alternative bonds issued by the same firm. If both bonds market
386 TS Y Ho and R.F Swzger,Bond indentures and yuk

values are equal, then the one with the longer maturity is more risky. In fact,
by the corbllary, the crisis at maturity, in this context, is imposed on the
firms stockholders rather than its bondholders. For example a continuing
policy of rolling over short-term debt is more risky to stockholders than a
policy of issuing the same amount of long-term debt initially.

4. Risk and the promised payment schedule

This section extends the analysis to consider the relative risk (elasticity) of
a portfolio of discount bonds, of different maturities, issued by the same firm.
Specifically, it examines the risk of multiple payment bond packages as the
promised payments are varied while the total market value of the package is
held constant. The analysis can be useful in examining the risk of alternative
bond packages with various degrees of reliance on short-term versus long-
term debt. These results can be applied to a multiple payment bond with
implications for the impact of the size of the promised~ coupon payment
relative to the promised payment at maturity, or more generally, for the rate
of amortization of an individual debt issue.

4.1. The model

The market assumptions (A.l) through (A.5) are retained. In this section,
assumption (A.6), describing the amount and timing of the promised payment
to the bondholder, is replaced by:
(A.7) The firms debt consists of two discount bonds: a short-term discount
bond with promised payment F, at maturity Ts and a long-term
discount bond with promised payment F, at maturity TL.
(A.8) The promised payment Fs is financed externally with_junior securities
(equity or debt junior to the existing bonds).

Unlike the dase of a single discount bond, the value and behavior of a bond
package depends on the means used to finance the early payment [Black and
Cox (1976)]. This section focuses on the behavior of the total debt package
as distinct from that of the component issues comprising the package. Thus
it is not necessary to consider the priority rules associated with the
component debt issues. The effect of the structure of priority rules on the risk
of the individual issues awaits development in section 6.
Geske (1977) derives the leverage ratio and the elasticity of the debt as
functions of the firms business risk, the timing and the amount of the
promised payments, the instantaneous riskless rate of interest and the
current value of the firm. For simplicity, it is assumed that the date of the
long-term promised payment is twice that of the short-term promised
payment (i.e., T, =iTL = T).
 TS Y Ho and RF Singer, Bond mdentures and vtsk 387

The leverage ratio D/V is expressed as

(4.1)

and the elasticity of the debt package y is

(4.2)

where l is the bankruptcy state at T,, given by the solution to

(4.3)

The function B(x) is given by

B(x) = N(y - ofi) exoJT-3aZ T + N( - y)f,, (4.4)

and y is related to parameter x by

y=a--x, (4.5)
where

is the bankruptcy state at T,,

fL= FL/VerTL

is the long-term quasi leverage ratio, and

fs = FS/VerTs

is the short-term quasi leverage ratio. Given the current value of the firm, eqs.
(4.1H4.5) determine the value and elasticity of a bond package consisting of
two discount bonds, with promised payments F, and FL, maturing at T, and
TL, respectively.
The parameter &j,determined by (4.3), gives the bankruptcy state at T,, and
N(E) is the risk-neutral probability of default at T,. Parameter a is the
bankruptcy state at TL, and N(y) is the risk-neutral probability of default at
TL, conditional on the state variable x determined at T,. B(x), in (4.4),
represents the Ts value of the long-term debt conditional on x (assuming the
short-term payment is made).
388 TS Y; Ho and R.F Smger, Bond zndentures and risk

4.2. Risk and long-term debt intensity

Within the context of the above model, long-term debt is substituted for
short-term debt. An increase m one promised payment alone increases both
the risk and market value of the debt. On the other hand, reducing the other
payment alone decreases the risk of the package.
The relative amount of long-term debt is characterized by the ratio fLlfS,
defined as the long-term debt intensity of the debt package. This measure is
proportional to the ratio of the promised payment to long-term bondholders
relative to the promised payment to short-term bondholders (the constant of
proportionality being edrT). Furthermore, the market value of long-term
debt, as a proportion of the market value of the total debt package, is an
increasing function of long-term debt intensity. Thus, an increase in long-
term debt intensity implies an increase in long-term debt relative to short-
term debt, both in terms of the bonds promised payments and in terms of
their market values. Theorem 2 examines the net effect of changes in long-
term debt intensity on the risk of the debt.

Theorem 2. Given the assumptions of this section, an increase (decrease) in

long-term debt intensity, holding the market value of the total debt package
unchanged, increases (decreases) the elasticity y of the total debt package.

Proof: The proof is similar to that in Theorem 1. However, instead of

simultaneously adjusting the promised payment and maturity to keep market
value unchanged, the two promised payments, F, and FL, are adjusted (while
keeping the payment dates, Ts and TL, fixed) to keep the market value of the
debt unchanged.
The debts elasticity depends on the bankruptcy state at Ts, the short-term
quasi leverage ratio, and the long-term quasi leverage ratio (5, fs and fL,
respectively). It is necessary to examine the relationship between the debts
elasticity and its long-term debt intensity, while holding the market value of
the debt unchanged. To keep leverage constant, eq. (4.6) must hold:

d(D/V)=N(-5)df,+ (4.6)

Furthermore, d{, dfS and dfL are related by the bankruptcy condition at Ts
[eq. (4.3)]. Differentiating (4.4) with respect to the three parameters l, fs and
fL gives this relationship as
m
JfW(-y)dx
ofi eeu~~-t-uTN(o~-a+~)dt-N(~-a)dfL=-r N(_i) dfL.

(4.7)
 TS I: Ho and RF Swgev, Bond Indentures and rusk 389

Finally, eq. (4.2) relates the elasticity to 5, fs and fL.Differentiatmg (4.2)

yields

(4.8)

Now, dt and df, can be eliminated by substituting (4.6) and (4.7) into (4.8),
and simplifymg, so that

(D,T/)ofi(dv/df,)
=f(tW(5 - 4 -& 7fWW -4 dx

+ 4<f(x)f(a - 4 dx
= d44 5). (4.9)
Thus,

Eq. (4.10) gives the effect of small changes in the firms long-term debt
intensity while holding leverage unchanged. Appendix B establishes that
4(u, 5) 1s positive for all values of a and t. Q.E.D.

Notice that the theorem is independent of the priority rules associated

with the individual issues within the debt package. The risk of a debt
package increases with long-term quasi leverage when the short-term quasi
leverage ratio IS adjusted to keep the market value of the package constant.
The magnitude of this increase depends on:
D/q the current leverage ratio,
7: the time to maturity of the promised payments,
a, the bankruptcy state at TL,
<, the bankruptcy state at T,,
c2, the instantaneous variance of the firms rate of return.
The corollary to Theorem 1 also applies to Theorem 2. It follows that the
equitys elasticity is a decreasing function of long-term debt intensity. That is,
bond indenture provisions which provide for periodic amortrzation of the debt
(through, for example, coupon payments or smkmg fund provrsions), increase
the risk to equity, and decrease the risk to debt.
Theorem 2 indicates that the risk of a coupon bond of a given maturity
and market value is less the larger the coupon payment (and the smaller the
390 TS.Y Ho and R.F. Singer, Bond mdentures and mk

promised payment at maturity). This appears to be consistent with the belief

that the risk of a bond issue can be reduced by spreading the promised
payments evenly over the life of the issue rather than having a large balloon
payment at maturity. However, spreading out the payments of a debt issue
by increasmg the time over which the payments are made has the opposite
effect. Thus the increased amount of earlier payments relative to later
payments is responsible for the risk reduction, rather than spreading, per se.

4.3. Risky corporate debt and effective maturity

This section shows that a risky debt package can be represented by a

single discount bond with the same risk and value as the package. Theorem
3 derives this representation:

Theorem 3. Gtven a debt package with promised payments Fs payable at Ts,

and F, payable at TL (Ts< TL), there exists a unique discount bond with
promised payment F payable at z, having the same risk and value. The maturity
z is an increasing functton of the debt packages long-term debt intensity. It is
independent of the priority rules associated with the mdividual issues comprising
the debt package. Furthermore, z takes on a value between Ts and T,.

Proof Let q, vs and yL be the elasticities of the bond package, a discount

bond of the same value issued by the same firm maturing at T,, and one
maturing at TL, respectively. Theorem 2 implies that

By Theorem 1, the relative risk of a discount bond increases with maturity,

holding market value constant. The theorem is proved by the Intermediate
Value Theorem. Q.E.D.

The maturity of the discount bond z is referred to as the effective maturity

of the bond package Notice that the elasticity of any risky bond package
can be described by its effective maturity and leverage. Furthermore, the
elasticity and effective maturity is independent of the priority rules associated
with the individual debt issues comprising the package.
Effective maturity is the risky debt analogue to that of stochastic duration
proposed by Cox, Ingersoll and Ross (1979). They show that a package of
default-free bonds, subject to term structure risk, can be represented by a
unique discount bond with the same risk (risk is measured by the
instantaneous standard deviation of the bond). The maturity of this discount
bond is defined as stochastic duration. Theorem 3 considers a package of
bonds subject to default risk and a known term structure. In this context,
effective maturity is the maturity of a discount bond with the same elasticity
and value as the package.
 TS Y Ho and RF Smger, Bond mdentures and risk 391

For a given firm, a rrsky bond packages elasticity depends on two

parameters: the market value of the debt and its effective maturity. In
contrast, given interest rate dynamics, the risk of a default-free bond package
depends only on its stochastic duration and is independent of the market
value of this package.

4.4. The sensitivity of risk to changes in long-term debt mtenstty

Theorem 2 establishes a positive relationship between long-term debt
intensity and the risk of a debt package. However, the sensitivity of risk to
the substitution of long-term debt for short-term debt depends on the level of
long-term debt intensity. Theorem 4 describes the sensitivity of changes in
risk to changes in the long-term promised payment.

Theorem 4. Define the sensitivity of risk to a change in long-term promised

payment as WdfL 1D,v. Then given assumptions (A.I)<A.5), (A.7) and (FM),

(i) lim dy/df, (D,v = 0.

.fL+O

That is, when there is no long-term debt, the risk of the debt package is
insensitive to the substitution of a small amount of long-term promised payment
for short-term promised payment, whtle keeping leverage unchanged,

(ii) lim drldfL )niV = e -4j&?(DJV) > 0.

fs-0

That is, when there is no short-term debt, the sensitivity of the risk of the debt
package to substitution of short-term promised payment for a small amount of
the long-term promised payment can be significant, depending on the leverage
ratio.

Proof From the definition of a, as fL -0, a+ - CC so that it suffices to show

that lim,, _ cody/df,=O. This is accomplished by considered the limiting
characteristics of each term in (4.9). Since N(x-a)-+1 as a+ - 00, the
Lebesgue Convergence Theorem [Royden (1968, p. 229)] gives

lim 7 f (x)N(x - a) dx = N( - <),

LI+-a) r

and also by the definition of N(s),

lim N(5-a)N(-_)=iV(-5).
67-02
392 TS.Y Ho and R.F Smger, Bond mdentures and risk

Finally, f(&N(--l)<t for all values of <. Thus the first term on the r.h.s. of
(4.9) converges to 0. Furthermore,

054 f(x)f(x-~)dx=(e-~~/&)~ .f(JZx-alJZ)dx~e-2i4i~.

t: 5
(4.11)
Since, lim,, _ o. e-a2/4 l&=0, the second term goes to 0. Hence all terms m
(4.9) go to zero as a goes to - 00, and part (i) is proved. To prove part (ii) of
the theorem note that

lim N( < - u)N( - l) = 0 and lim f (t)/N( - <)= 0.

<--CC t--m

Thus the first term on the r.h.s. of (4.8) converges to 0. Furthermore, from
(4.1 l),

lim 4 f(x)f(x - a) = e-aZ/4/1/2n. Q.E.D.

T4-m 5

The intuition underlying Theorem 4 can be explained by considering the

effect of a change in long-term promised payment on the probability of
bankruptcy at Ts and TL. When there is no long-term debt, marginal
substitution of a long-term promised payment for some short-term promised
payment would have little effect on the probability of bankruptcy at TL
conditional on the firm avoiding bankruptcy at T,. This is because a small
promised payment does not substantially increase the conditional probability
of bankruptcy, compared to no promised payment at that time. In both cases
the probability of default is minimal. Furthermore the bankruptcy state < at
Ts depends on both the short-term promised payment F, and the T, value of
the long-term promised payment, B(x). Since B(x) is essentially risk-free, it is
close to fL. Thus, the substitution entails substituting B(x) for fs in such a
way that the bankruptcy state c is not substantially affected. On the other
hand, substituting a short-term promised payment for some of the long-term
promised payment when there is no short-term debt, substantially reduces
the risk of the debt package. In this case the probability of default at Ts is
not significantly effected since, again, this represents simply a reduction in
B(x) for an approximately equal increase in fs. However, since the long-term
debt is risky, a small decrease in B(x) implies a relatively large decrease in
the promised payment fL. This substantially decreases the probability of
default at TL and hence the risk of the package.
 TS Y Ho and R.F Smger, Bond mdentures and ruk 393

5. Financing restrictions

This section considers the impact of restrictions on the means of financing

the debt payments. Up to this point, it has been assumed that all debt
payments are financed externally through junior securities. This represents a
constraint on the firms financing ability. When there are multiple bond
payments, the firm would, if permitted, finance early payments either
internally, or by issuing new senior securities. This strategy, ceteris paribus,
reduces the value of the remaining debt, increasing stockholders wealth.
Although typical indenture provisions prohibn the firm from issuing senior
securities, there is some ability to finance debt payments by internally
generated funds [Smith and Warner (1979)].
To consider the effect of a less restrictive financing covenant, this section
reformulates the bond valuation model permitting the firm to finance the
promised payment internally. Assumptions (A.1j(A.5) in section 2 and (A.7)
in section 4 are retained. The financing assumption (A.8) is replaced by (A.9).
(A.9) The short-term promised payment F, is financed internally by the sale
of assets. These assets are sold in a perfect market and the value of the
firm continues to follow the Wiener process described in assumption
(A.4).*
This modification affects the value and risk of the total debt package m
two ways. First, the probability of default on the short-term promised
payment Fs is reduced since the firm is wrlling to finance this payment as
long as the total value of the firm exceeds the promised payment. Second, the
sale of assets imposes additional risk on the remaining debt, and increases
the probability of default on the long-term promised payment F,. Thus the
change in financing rules can be seen as shifting the probability of default
from the short-term promised payment to the long-term promised payment.
Theorem 5 demonstrates that none of the results established so far is affected
by this alternative financing arrangement.

5.1. The model

Using assumptions (A.lHA.4) (A.7) and (A.9), eq. (5.1) describes the
leverage ratio as

D/V= N(z - ofi) +fsN( -z) + 1f(x)B(x) dx, (5.1)

These assumptions are imposed to neutralize the investment dectsrons impact on the total
rusk of the firm. This isolates the Impact of the sale of assets on the relative rusk of the financral
claims issued by the firm. The assumptions hold d the pnce of the assets equals its present value,
the risk of the sold assets equals the risk of the firm, and the assets return IS perfectly correlated
wrth the return of the firm.
394 T.S I7 Ho and R F. Smger, Bond indetures and mk

and the debts elastrcity is given by

r/=(V/D) N(z-aJT)+~.f(x-o~)N(y--~)dx (5.2)

(5.3)

Y= ln [IfJW) -fsW-Jr +&E (5.5)

where
v(x) = eaJ;x - *a2T.

This system of equations differs from (4.1)-(4.5) by the specification of the

bankruptcy states at T, [eq. (5.3)] and at TL [eq. (5.5)]. The former
bankruptcy state declines while the latter increases. Further, the sale of assets
at Ts decreases the ?&value of the long-term promised payment [eq. (5.4)].
This difference in valuation can be related to the decision of the firm at the
time the short-term promised payment is due. When financing this payment
is restricted by assumption (A.Q default ,is avoided if the equity value exceeds
the value of the promised payment. Hence, m this case, the value of the firm
must be greater than the sum of the short-term promised payment and the
Ts value of the long-term promised payment. However without this
restriction [assumption (A.9)], the firm will make the short-term payment as
long as it is less than the total value of the assets. The firm will ignore the
long-term promised payment since rt can always undermine the market value
of this payment by selling assets at Ts. This serves to increase the present
value of the short-term obligation but decrease the present value of the long-
term obligation.
Theorem 5 describes the relationship between risk and long-term debt
intensity under the financing rule governed by assumption (A.9).

Theorem 5. If the short-term promised payment is financed with the sale of

assets, the qualitative relationship between long-term debt intensity and the risk
of the debt package is described by Theorems 2, 3 and 4.

Proof. The basic idea of the proof is similar to that of Theorem 2. When
the long-term promised payment increases (dfL > 0), the short-term promised
payment has to be adjusted downward so that the debts value remains
constant. Consequently, bankruptcy states z and y would be affected (dz #O
and dy # 0).
 lXY Ho and RF. Smger, Bond mdentures and mk 395

To account for the interrelationship among the four components (dz, dy,
df,, dfL) in differentiating eq. (5.1), the following equation has to hold:

dL=~dj,+~dfL+~dz+~dy=O for L=D/K (5.6)

S L

Now eq. (5.5) requires that

dy= WfLo,b +dfslM4 -fs)gJ7.

From eq. (5.2), a direct calculation shows that

Substituting eqs. (5.6) and (5.7) into eq. (5.8) and simplifying, it can be shown
that (details are given in appendix C)

drlldfL = @(fs, a)/(DlV)&

where
rm 1
@(fs,a)= J N(-x(h))f(a-h)dh [IG(fs, a)-G(f,,a- az/T)l, (5.9)
1 -m 1

G(f,,a)= r f(x(h))f(a-h)dh 4 N(-x(h))f(a-h)dh, (5.10)

-X -CC
and

G(f,, a) is an increasing function of the parameter a. It follows that,

dq/df,>O, and the first part of the theorem is proved.
Furthermore, since G(f,, a)>0 and aG/aa> 0, G tends to a bounded value
as a becomes arbitrarily small, and

lim i N(-x(h))f(a-h)dh=O.
a-rm -00

It follows that

lim dy/dfL = 0.
a-r-m
396 TS Y Ho and RF. Smger, Bond mdentures and rwk

Thus, the risk is insensitive to the change of long-term debt intensity when
there is no long-term debt. On the other hand, a direct calculation shows
that, from eqs. (5.9) and (5.10), @(O,u)>O, so that the debt packages risk is
sensitive to the change in the long-term debt intensity when there IS no
short-term debt. Q.E.D.

Theorem 5 indicates that the major qualitative conclusions of this paper

do not depend on whether the firm is restricted to financing debt payments
externally [assumption (A@] or if it is permitted to engage in internal
financing without restrictions [assumptron (A.9)]. Neither rule is
representative of financing restrictions contained in typical indentures. Some,
but not unlimited, internal financing is generally permitted. For example,
operating income may be used to finance debt payments while limits are
placed on the sale of fixed assets. The theorem suggests that these partial
restrictions would not affect the qualitative results derived in previous
sections.

6. Priority rules and the risk of component issues

This section focuses on the risk of individual issues comprising the debt
package. Previous sections dealt with the risk of the total debt package so
that there was no need to specify the priority rules association with each
bond. However, the allocation of the risk among the component issues
depends on the structure of priority rules associated with each issue.
Define senior debt as a debt issue whose payment upon default IS
independent of the level of junior debt [see Fama and Miller (1972)]. Then
the analysis considers two possible cases: (i) long-term debt senior to short-
term debt, and (ii) short-term debt senior to long-term debt. Assumptions
(A.lHA.8) are employed so that perfect market conditions obtain and all
debt payments are financed externally through equity issues. Under these
assumptions, the value and risk of the senior issue can be derived
independently of the junior issue. Since the risk of the total package is
independent of priority rules, the risk of the junior debt can then be
determined as the risk of the total package not allocated to the senior debt.
Specifically, the allocation of risk between the two issues described in the
assumptions can be expressed as

where y, ys and ~~ are the elasticities of the total debt package, the short-
term debt and the long-term debt, respectively. D,/D and D,/D are the
market values of short-term and long-term debt respectively, as proportrons
of the market value of the total debt.
 TS Y Ho and R.F Smger, Bond indentures and rusk 397

The following sections describe the risk of the component issues as the
debt packages long-term debt intensity changes.

6.1. Short-term debt senior to long-term debt

This section considers the allocation of the risk of the debt package
between a short-term senior and a long-term Junior debt issue as the effective
maturity of the debt package increases. It has been established, in Theorem
3, that the risk of the debt package is an increasing function of effective
maturity. Thus the elasticity of the debt package can be represented by the
curve AB in fig. 3.

Elasticity of Each
Debt Issue

Maturity

Fig 3 The debt package consists of two discount bonds: one maturing at q (short-term debt)
and the other maturmg at TL (long-term debt) The effective maturity of the debt package IS the
maturity of the discount bond havmg the same elastlclty and value as the debt package The
value of the debt package IS assumed to remam constant The elastlclty of long-term Jumor debt
IS given by curve GB The elastlclty of short-term semor debt IS given by curve AC The
elastlclty of the debt package IS aven by curve AB

By the definition of seniority, the short-term senior debt can be treated as

a discount bond with promised payment F, and time to maturity T,. Merton
(1974) has shown that the risk of a discount bond is an increasing function of
quasi leverage. It follows that, since short-term quasi leverage is a decreasing
398 TS Y Ho and R.F. Smger, Bond mdentures and risk

function of effective maturity (Theorem 3), so is the risk of the senior short-
term issue. The risk of the semor issue can be represented by curve AC in fig.
3. As effective maturity goes to Ts, long-term debt goes to zero and the risk
of the short-term senior issue goes to the risk of the package. As the effective
maturity goes to TL, the value and risk of the short-term debt go to zero.
The risk of the long-term junior debt can now be derived for all effective
maturities between Ts and TL. Its elasticity is represented by curve GB m fig.
3. Since the allocation of risk obeys eq. (6.1), the elasticity of the long-term
junior debt is a decreasing function of effective maturity. It converges to the
elasticity of the debt package as effective maturity goes to TL. As one would
expect, the senior issue is less risky than the junior issue for all levels of
effective maturity.

6.2. Long-term debt senior to short-term debt

When long-term debt is senior to the short-term debt the allocation of risk
for different levels of effective maturity is considerably more interesting. The
relationship between the elasticity of the debt package and effective maturity
can again be represented by an increasing curve such as AB in fig. 4. The
long-term senior issue can again be treated as a discount bond, its risk
increasing with quasi leverage. Thus, in this case the risk of the senior long-
term issue is an increasing function of effective maturity, converging to zero
as effective maturity goes to Ts, and converging to the elasticity of the debt
package as effective maturity goes to Tt. This is represented by curve OGB in
fig. 4.
Now, the elasticity of the short-term junior debt can be examined as
effective maturity changes. When effective maturity goes to T,, long-term
debt goes to zero and thus the risk of the short-term debt converges to the
risk of the debt package at A. On the other hand, as effective maturity goes
to TL, the short-term promised payment becomes negligible. Hence the
probability of default at T, becomes negligible and the short-term debt
becomes risk-free. Thus the relationship between risk and effective maturity
for short-term junior debt can be represented by curve ADGC.
Notice that the curvature of ADGC and OGB shows that there exists an
effective maturity between T, and TL where the elasticity of the long-term
senior issue is equal to the elasticity of the short-term junior issue. This point
is represented by G, the package with effective maturity zO. The long-term
senior debt is less risky than the short-term junior issue when effective
maturity is less than zO. For effective maturities greater than z0 the short-
term junior issue is less risky than the long-term senior issue.
In conclusion, when short-term debt is senior to long-term debt then the
risk of the senior issue is always less than the risk of the junior issue and is
increasing with its promised payment. On the other hand, when senior debt
 TS Y Ho and RF Smger, Bond mdentures and risk 399

i%rticity of Each
Debt Issue

Elasticity
of long-term

Effective
7 Maturity
0 TL

Fig 4 The debt package consists of two drscount bonds one maturing at Ts (short-term debt)
and the other maturing at TL (long-term debt) The effective matunty of the debt package IS the
maturity of the discount bond havmg the same elastmrty and value as the debt package The
value of the debt package IS assumed to remam constant The elastrctty of long-term semor debt
1s given by curve OGB The elastrnty of short-term mmor debt IS given by curve ADGC The
elastmrty of the debt package IS given by curve AGB The senior debt and Jumor debt have the
same elastrcrty when the effective maturity of the debt package IS zO, and the elastrctty of the
short-term nnnor debt reaches the maximal value at D.

is long-term, then the results are less obvious. It can no longer be argued
that senior debt is inherently less risky than the subordinated debt in the
same firm. This is because jumor short-term debt will almost certainly be
paid in full as long as the promised payment to this debt is sufficiently small.
If the firm adds short term debt, its risk will increase, reaching an interior
maximum. Thereafter, further increases in short-term junior debt, while
holding leverage unchanged, tends to reduce the risk of that debt issue. This
IS a consequence of the decrease in the senior claims as the firm substitutes
short-term for long-term. This reduces the amount of prior claims associated
with the short-term debt, tending to reduce its risk.

7. Conclusions

This paper examines the effect of alternative bond indenture provisions on

the allocation of risk among the firms claimants. The approach taken here
400 l3.X Ho and R.F Smger, Bond mdentures and risk

differs from that of earlier studies in that risk allocation is examined while
the firms leverage (in market value terms) is held constant. In this context,
four indenture provisions are examined: (1) the time to maturity, (2) the
promised payment schedule, (3) financing restrictions, and (4) priority rules.
This approach provides additional insight mto the impact of these
indenture provisions on the allocation of risk. It is concluded that risk is
transferred from stockholders to bondholders as the time to maturityand
promised payment increase appropriately (Theorem 1). Furthermore
substitution of longer-term debt for an equal amount of shorter-term debt
also increases the risk to bondholders while decreasing the risk to
stockholders (Theorem 2). The analysis shows that a coupon bond (or a
package of discount bonds) can be represented by a unique discount bond
with the same risk and value (Theorem 3). This permits the characterization
of the effective maturity of a risky debt issue, a concept analogous to the
stochastic duration of a default-free coupon bond. Furthermore, most of the
qualitative results in the paper are shown to be independent of the means
used to finance the debt issue (Theorem 5). Finally, it is concluded that the
relative risk associated with different bonds issued by the same firm cannot
be determined by the structure of priority rules alone. It is also necessary to
consider the timing of the promised payments compared to that of the other
debt issues in the firms capital structure.
These results are consistent with recent empirical studies on bond risk.
Weinstein (1981) shows that risk, measured by a bonds beta, is positively
related to the time to maturity and negatively related to the coupon rate.
These results can be explained by Theorems 1, 2, and 3 relating bond risk to
maturity and the promised payment schedule. However, the relationship
between bond risk and the timing of the promised payments depends
crucially on whether a given leverage ratio is defined by its market value or
book value. This suggests that empirical investigators should pay special
attention to the specification of the leverage ratio as an explanatory variable.

Appendix A

Given that z and z are related by

D 1 N&o&) N(-2)
07 j+-CLJ)-f(Z-cT&) =ZY-
(A.1)

it is necessary to show that

lim N(z - CJ&) = D/I/:

 TS I! Ho and RF Smgev, Bond mdentures and rusk 401

Now let the parameters x and y be defined by

x=2--c7 vf 7, y= -2.

Then eq. (A.l) may be represented by

W) = 43(Y) 04.2)
where
N(X) 1 -
6_(X)=fo and +(X)= 0 g --
V f(X) 4(x)*

The graphs of $ and 6 are given in fig. 5. Referring to the figure, let AB be

unction Values

Fig 5 A geometric proof showing that the bond elasttclty approaches one as time to maturity
goes to mkuty. The function q(x) is given by &c)=N(x)/f(x) where N(x) is the cumulative
normal density function and f(x) ts the normal density function. The function t&x) 1s given by
I&X)=(D/V)(l/f(x))- d(x), where (D/V) is the leverage ratio. Smce the parameters z and ~4 are
related by (l/(z - gJ) =6(-z), it follows from the figure that when z = AO, then (Z-O&) = OB
In particular, when z tends to mfimty, (Z-CT&) tends to x,0.
402 TS Y Ho and RF Smgev, Bond mdentures and nsk

any horizontal line. Then eq. (A.2) requires z and z be related by points A
and I?. That is,

z=AO and z-o&=OB.

Notice that, if x0 is determined so that $(x0) = 0, it follows that

D
or N(x,)=/.

Now as z increases, z also increases. As a consequence, the line Al? shifts

down and (z-~,,f) r increases. Hence as r-+co, z is not bounded above so
that it tends to infinity. But from fig. 5, (Z--C&) is bounded by x0 since
6(x)>& and $(X)-CO for any x>xO. This means that as z-+cc (note that
the line AB must decrease, approaching the x-axis, Hence lim,, m(z

Appendix B

Let

Proposition B.I. For a-+co, &z, a)-+0 for each value of z.

Proof. N(z-a)N( -z)+O as a-+oo follows from the definition of N(x). For
the second term,

Osyf(x)N(x-a)dxi q f(x)N(x-a)dx.
z -cc

For ado, the right-hand side converges to zero. Finally,

Since e-az/2/J%-+0 as a-+co, we have shown that every term converges to

0.

Proposition B.2. For a+ - GO,4(z, a)-+O.

 TS Z Ho and RF Smger, Bond mdentures and rusk 403

ProoJ: From the proof in Proposition B.l, we have shown that

hm 7 f(x)f(x - a) dx = 0.
a+m Z

Now N(z-a)N( -z)--+N( -2) as a-+ - co by the definition of the function

N(x). Finally, since N(x - a) + 1 as a + - co, Lebesgue Convergence Theorem gives

qf(x)N(x-a)dx-*N(-z) for a-co.

Thus the result follows.

Proposition B.3. 4(.z, a)+0 as z-co.

ProoJ: By direct calculation and noting that J: f(x)N(x- a) 5 N( -z) one

can show that each term in the expression &~,a) converges to zero.

Proposition B.4. For z-+ -co, 4(z, a)+e-aZi4/2&

ProoJ Since j: f(x)N( - a) dx - N(z - a)N( - z) is bounded, and f(z)-+0 for

z-+-co, then

yj(x)N(x-a)dx-lv(z-n)rj(-z) as z-+-co.

Furthermore,

~f(x)f(x-a)dx=(e-~4/,,/!%) g/($x->)dx.

Hence, for z-+ - co, $(z, a)-+( - l/2&) e-14.

Proposition B.5. For a given z, there 1s only one value a*, such that

ProoJ By a direct calculation, one can show that

JFCB
404 TS Y Ho and RF Smger, Bond indentures and ruk

where v(x)=f(x)/N(-x) and v-(x) is Mills ratio. It has the property that
O<v < 1 and for large value of x, v(x)=x [Kendall and Stuart (1977)].
Therefore, either (i) &$/aa#O for any value of a or (ii) there exists a unique
value a, such that (&#/&)(a, a,) =O. However the first case contradicts
Propositions 1 and 2. Q.E.D.

Propositions B.l-B.5 show that $(z, a) r 0 for any value z and a.

Appendix C

The bond model may be described by eqs. (C.l) to (C.5),

D/V = N(z - a@) +f&z)

-
+ 7
2
f(x)!(x) dx, (C.1)

where

w =NY - Qmx) --.I4+ N - VW-L, (C.2)

v(x) = e dJ% - +a2 T

7 (C.3)

fs=W), (C.4)

and finally,

Y= ln LX/W -h)ll~ JT +&Jr. (C.5)

From (C.5),

W = dfXafi +MS/W)-_f&& (C.6)

Furthermore, from (C.l), the following equation can be derived:

O=d&N(-z)-yf(x)N(y-afi)dxd&+rf(x)N(-y)dxdf,. (C.7)
z

Eqs. (C.6) and (C.7) together give

dfi.
J f (W(-y)dx
dy=
fLa$F+ 1f(x)N(y'-afi)dx-N(-zz') (v(x)-~afi
 TS Y Ho and R F. Singer, Bond mdentures and rusk 405

Hence, from the definition of the elasticity, it can be shown that

1fGW( - Y)dx
+
@x)IV(+c~fi)dx-IV-z)
1

x7
z
f(x-aJT)f(~'--o)l(v(x)-fs)d~. (C.9)

Note that

f(x - OfiT) =f(x)v(x),

and

f(Y - C-JJr) =f(YK/w) -hi).

Furthermore, defining

h=a-y where a=lnf,laJT++aJ?;,

eq. (C.9) can be expressed in the form required in Theorem 5.

References
Black, F and J.C Cox, 1976, Valumg corporate securities Some effects of bond indenture
provistons, Journal of Fmance 31, May, 351-367
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