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Contingent Government Liabilities against
Private Expectations in England, 1743-49
(May 2007)
England
financed its war of the Austrian succession (1743-48)
mainly by issuing 3 % bonds and 4 % callable bonds which
were indeed redeemed by Pelham in 1749 through an interest
reduction. The implicit policy rules and constraints made
the 4 % bond a derivative asset of a 3 % perpetual. The
price data fit with a model of pricing of this derivative.
The estimated model shows that the redemption terms were
well anticipated, but government bond prices recovered
after the war much sooner than expected. Callable bonds
enabled the government to exploit that excess of pessimism
in reducing its borrowing cost.