Pricing credit-risky bonds using recovery rate uncertainty and macro-regime switching

Son-Nan Chen, Pao-Peng Hsu and Kuo-Yuan Liang

The European Journal of Finance, 2024, vol. 30, issue 2, 127-143

Abstract: A proposed model is used to account for both the recovery rate and regime-switching uncertainties for pricing credit-risky bonds. A two-factor hazard rate model (TFHRM) is also considered, where the dynamics of both instantaneous forward rates and asset values are modeled using Markov-modulated geometric Brownian motions (MMGBMs). Moreover, a macroeconomic factor is incorporated into the MMGBMs. The model complexity is resolved through the introduction of an endogenous intensity function and a recovery rate under the TFHRM. A semi-closed-form solution for pricing defaultable bonds is derived along with a pricing formula for credit spread. A credit cycle is constructed to reflect changes in industry characteristics and macroeconomic factors. The empirical study demonstrates that the inclusion of a stochastic recovery rate increases the model’s pricing accuracy, and the results indicate a close interaction among business cycles, recovery rates, and credit ratings.

Date: 2024
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Persistent link: https://EconPapers.repec.org/RePEc:taf:eurjfi:v:30:y:2024:i:2:p:127-143

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DOI: 10.1080/1351847X.2023.2193703

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