When a corporation plans to finance its investment through the issuance of bonds, the corporate management may choose either fixed or floating interest rate debt. Since the issuing corporation is inevitably subject to default risk, the issued bonds must provide higher yields than the default-free instruments. It has been observed that the required default premium of fixed rate debt is higher than that of the floating debt for firms with the same credit ratings. In this thesis, the contingent claim approach is employed to investigate the factors which determine the fixed-floating differentials. This thesis extends earlier works by allowing intertemporal default possibilities of the firm and incorporating different classes of interest rate models. It is discovered that the correlation coe...[ Read more ]

When a corporation plans to finance its investment through the issuance of bonds, the corporate management may choose either fixed or floating interest rate debt. Since the issuing corporation is inevitably subject to default risk, the issued bonds must provide higher yields than the default-free instruments. It has been observed that the required default premium of fixed rate debt is higher than that of the floating debt for firms with the same credit ratings. In this thesis, the contingent claim approach is employed to investigate the factors which determine the fixed-floating differentials. This thesis extends earlier works by allowing intertemporal default possibilities of the firm and incorporating different classes of interest rate models. It is discovered that the correlation coefficient between the firm value process and the interest rate process has profound impact on the fixed-floating differentials.