A NOTE ON RISKY BOND VALUATION

C. H. Hui () and C. F. Lo ()
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C. H. Hui: Banking Policy Department, Hong Kong Monetary Authority, 30th Floor, 3, Garden Road, Hong Kong, China
C. F. Lo: Physics Department, The Chinese University of Hong Kong, Shatin, Hong Kong, China

International Journal of Theoretical and Applied Finance (IJTAF), 2000, vol. 03, issue 03, 575-580

Abstract: This paper develops a corporate bond valuation model that incorporates a default barrier with dynamics depending on stochastic interest rates and variance of the corporate bond function. Since the volatility of the firm value affects the level of leverage over time through the variance of the corporate bond function, more realistic default scenarios can be put into the valuation model. When the firm value touches the barrier, bondholders receive an exogenously specified number of riskless bonds. We derive a closed-form solution of the corporate bond price as a function of firm value and a short-term interest rate, with time-dependent model parameters governing the dynamics of the firm value and interest rate. The numerical results show that the dynamics of the barrier has material impact on the term structures of credit spreads. This model provides new insight for future research on risky corporate bonds analysis and modelling credit risk.

Date: 2000
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DOI: 10.1142/S0219024900000656

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