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Setting the optimal make-whole call premium

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  • Eric A. Powers
  • Sudipto Sarkar

Abstract

With a make-whole call, the call price is calculated as the maximum of the par value and the present value of the bond's remaining payments discounted at the prevailing risk-free rate plus a pre-specified spread known as the make-whole premium. The commonly accepted thumb rule in the investment banking community is to set the make-whole premium at 15% of the at-issue credit spread. Using a standard structural model, we calculate the optimal make-whole call premium, i.e. the make-whole premium that maximizes the ex-ante firm value subject to managers following a second-best call policy that maximizes the ex-post equity value. For reasonable parameterizations, optimal make-whole premiums are relatively close to 15% of the model-generated credit spread. Thus, the 15% thumb rule provides surprisingly good guidance for setting make-whole call premiums.

Suggested Citation

  • Eric A. Powers & Sudipto Sarkar, 2013. "Setting the optimal make-whole call premium," Applied Financial Economics, Taylor & Francis Journals, vol. 23(6), pages 461-473, March.
    • Handle: RePEc:taf:apfiec:v:23:y:2013:i:6:p:461-473
    DOI: 10.1080/09603107.2012.727972
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    Cited by:

    1. Brown, Scott & Powers, Eric, 2020. "The life cycle of make-whole call provisions," Journal of Corporate Finance, Elsevier, vol. 65(C).
    2. Eric Powers, 2021. "The Optimality of Call Provision Terms," Management Science, INFORMS, vol. 67(10), pages 6581-6601, October.
    3. Afik, Zvika & Jacoby, Gady & Stangeland, David & Wu, Zhenyu, 2019. "The make-whole and Canada-call provisions: A case of cross-country spillover of financial innovation," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 61(C), pages 120-127.

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