Pricing Corporate Bonds With Interest Rates Following Double Square-root Process

Chi-Fai Lo and Cho-Hoi Hui
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Chi-Fai Lo: The Chinese University of Hong Kong
Cho-Hoi Hui: Hong Kong Monetary Authority

No 112016, Working Papers from Hong Kong Institute for Monetary Research

Abstract: This paper develops a corporate bond pricing model following the structural approach in which the dynamics of the instantaneous risk-free interest rate are governed by a double square-root (DSR) process. Credit spreads generated from this pricing model depend explicitly upon the levels of interest rates via a nonlinear effect arising from a DSR process. Given a positive correlation between interest rates and leverage ratios, the credit spreads generated by this pricing model have a negative relationship with interest rates, that is consistent with empirical findings using bond market data over the period 2008-2013 when interest rates were low.

Keywords: Corporate bond pricing model; Stochastic interest rate; Leverage ratio (search for similar items in EconPapers)
JEL-codes: G13 G21 G28 (search for similar items in EconPapers)
Pages: 38 pages
Date: 2016-06
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Citations: View citations in EconPapers (3)

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