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The Effect of Interest Rate Volatility and Equity Volatility on Corporate Bond Yield Spreads: A Comparison of Noncallables and Callables

Dr. Dong Hyun Kim and Dr. Duane Stock
Ohio Northern University

This research investigates the impact of interest rate volatility upon corporate bond yield spreads.  We first consider the impact of interest rate volatility upon noncallable bond spreads. Because greater interest rate volatility likely increases the volatility of the firm’s debt, we hypothesize the relation will be positive.  Given that we do find a positive relation, we thus investigate whether the positive effect of interest rate volatility on yield spreads is stronger or weaker for callable bonds. We find that the effect is weaker for callable bonds. This result indicates there is a negative relation between default spreads and call spreads, which is consistent with theory of Acharya and Carpenter (2002), but in contrast to the theory of King (2002). Furthermore, our results for the relationship between equity volatility and yield spread tend to support Acharya and Carpenter (2002) more than King (2002).