The valuation of corporate debt is an important issue in asset pricing; while there has been an enormous amount of theoretical modeling of corporate bond prices, there has been relatively little empirical testing of these models. Recently there has been extensive development of rating based reduced form models. These models take as a premise that bonds when grouped by ratings are homogeneous with respect to risk. For each risk group the models require estimates of several characteristics such as the default probabilities and the recovery rate. These estimates are then used to compute the theoretical price for each bond in the group.
The purpose of this paper is to examine the pricing of corporate bonds when bonds are grouped by ratings and to investigate the ability of characteristic, in addition to bond rating. In this paper the characteristics of bonds that vary within a rating class are as follows; A. Default Risk B. Liquidity C. Tax Liability D. Recovery Rates E. Bond Age
As expected, the results of the empirical analysis for all the characteristics of the bonds are consistent with pricing errors and conclude that these are factors that could lead price differences but bond age.