Inconsistent Bond Pricing in a Rational Market

Hong-Yi Chen and Hsiao-Yin Chen ()
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Hong-Yi Chen: Department of Finance, National Chengchi University, No. 64, Sec. 2, Zhinan Rd., Taipei, Taiwan
Hsiao-Yin Chen: Department of Business and Entrepreneurial Management, Kainan University, No. 1, Kainan Rd., Luzhu District, Taoyuan City, Taiwan

Review of Pacific Basin Financial Markets and Policies (RPBFMP), 2016, vol. 19, issue 03, 1-17

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 (search for similar items in EconPapers)
Date: 2016
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DOI: 10.1142/S021909151650017X

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