Bond and CDS Pricing via the Stochastic Recovery Black-Cox Model
Albert Cohen () and
Nick Costanzino ()
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Albert Cohen: Department of Mathematics, Michigan State University, East Lansing, MI 48824, USA
Nick Costanzino: Quantitative Analytics, Barclays Capital, 745 7th Ave, New York, NY 10019, USA
Risks, 2017, vol. 5, issue 2, 1-28
Building on recent work incorporating recovery risk into structural models by Cohen & Costanzino (2015), we consider the Black-Cox model with an added recovery risk driver. The recovery risk driver arises naturally in the context of imperfect information implicit in the structural framework. This leads to a two-factor structural model we call the Stochastic Recovery Black-Cox model, whereby the asset risk driver A t defines the default trigger and the recovery risk driver R t defines the amount recovered in the event of default. We then price zero-coupon bonds and credit default swaps under the Stochastic Recovery Black-Cox model. Finally, we compare our results with the classic Black-Cox model, give explicit expressions for the recovery risk premium in the Stochastic Recovery Black-Cox model, and detail how the introduction of separate but correlated risk drivers leads to a decoupling of the default and recovery risk premiums in the credit spread. We conclude this work by computing the effect of adding coupons that are paid continuously until default, and price perpetual (consol bonds) in our two-factor firm value model, extending calculations in the seminal paper by Leland (1994).
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JEL-codes: C G0 G1 G2 G3 M2 M4 K2 (search for similar items in EconPapers)
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Persistent link: https://EconPapers.repec.org/RePEc:gam:jrisks:v:5:y:2017:i:2:p:26-:d:96172
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