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Corporate Bond Valuation with Both Expected and Unexpected Default

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Abstract

This paper presents three variants of a tractable structural model in which default may take place both expectedly and unexpectedly. The model has the merit of predicting realistically high short term credit spreads. Closed form solutions are provided for corporate bonds (and default swaps) when interest rates are constant or stochastic and when the bond recovery value is exogenous or endogenous to the model. The analysis suggests that, in order for the observed short term yield spreads on high grade corporate bonds to be compensation for credit risk, bond holders must believe that a dramatic sudden plunge in the firm's assets value is possible, even if extremely unlikely.

Suggested Citation

  • Marco Realdon, "undated". "Corporate Bond Valuation with Both Expected and Unexpected Default," Discussion Papers 03/21, Department of Economics, University of York.
    • Handle: RePEc:yor:yorken:03/21
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    References listed on IDEAS

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    1. Jan Ericsson & Joel Reneby, 1998. "A framework for valuing corporate securities," Applied Mathematical Finance, Taylor & Francis Journals, vol. 5(3-4), pages 143-163.
    2. Mella-Barral, Pierre & Perraudin, William, 1997. "Strategic Debt Service," Journal of Finance, American Finance Association, vol. 52(2), pages 531-556, June.
    3. Leland, Hayne E, 1994. "Corporate Debt Value, Bond Covenants, and Optimal Capital Structure," Journal of Finance, American Finance Association, vol. 49(4), pages 1213-1252, September.
    4. Longstaff, Francis A & Schwartz, Eduardo S, 1995. "A Simple Approach to Valuing Risky Fixed and Floating Rate Debt," Journal of Finance, American Finance Association, vol. 50(3), pages 789-819, July.
    5. Pierre Mella-Barral & Pierre Tychon, 1996. "Default Risk in Asset Pricing," FMG Discussion Papers dp250, Financial Markets Group.
    6. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
    7. Jan Ericsson & Olivier Renault, 2006. "Liquidity and Credit Risk," Journal of Finance, American Finance Association, vol. 61(5), pages 2219-2250, October.
    8. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-654, May-June.
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    Cited by:

    1. Regis Houssou & Olivier Besson, 2010. "Indifference of Defaultable Bonds with Stochastic Intensity models," Papers 1003.4118, arXiv.org.
    2. Hyong-Chol O & Ning Wan, 2013. "Analytical Pricing of Defaultable Bond with Stochastic Default Intensity," Papers 1303.1298, arXiv.org, revised Apr 2013.

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    More about this item

    Keywords

    Corporate bond valuation: Structural model; Unexpected default; Short term credit spreads; endogenous bond recovery value; plunge of assets value;
    All these keywords.

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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