This thesis empirically tests a structural model of corporate bond pricing that incorporates the feature of mean reverting leverage ratio. It is known that firms set up a target leverage ratio and dynamically move towards their target leverage ratio. However most structural models but Collin-Dufresne and Goldstein(2001) preclude firms from altering their capital structures.
Implementing CG model, I simplify the model by assuming that interest rate follows a deterministic process. First two different methods are tried in order to estimate appropriate parameter values. The parameter values obtaining from regressions produce a wide range of prediction errors. Parameter values implied from actual bond prices over-predict credit spreads and also show a wide range of prediction errors. Second I investigate the systematic errors causing over-prediction or under-prediction of credit spreads, and test to what extent the credit spreads traded in the Korean bond markets reflect the mean reverting feature of leverage ratio.
Major factors causing the systematic errors turn out to be current leverage ratio and asset volatility, and I come to a conclusion that credit spreads in the Korean bond market do not reflect the feature of mean reverting leverage ratio as CG model predicted. For the purpose of the proper implementation of the model considered in this thesis, more investigations about the target leverage ratio and the speed of adjustment to the target leverage ratio are necessary.
