Pricing defaultable bonds: a middle-way approach between structural and reduced-form models

Lara Cathcart and Lina El-Jahel

Quantitative Finance, 2006, vol. 6, issue 3, 243-253

Abstract: In this paper we present a valuation model that combines features of both the structural and reduced-form approaches for modelling default risk. We maintain the cause and effect or 'structural' definition of default and assume that default is triggered when a state variable reaches a default boundary. However, in our model, the state variable is not interpreted as the assets of the firm, but as a latent variable signalling the credit quality of the firm. Default in our model can also occur according to a doubly stochastic hazard rate. The hazard rate is a linear function of the state variable and the interest rate. We use the Cox et al. (A theory of the term structure of interest rates. Econometrica, 1985, 53(2), 385-407) term structure model to preclude the possibility of negative probabilities of default. We also horse race the proposed valuation model against structural and reduced-form default risky bond pricing models and find that term structures of credit spreads generated using the middle-way approach are more in line with empirical observations.

Keywords: Stochastic term structure; Defaultable bond; Credit spread; Probability of default; Hazard rate (search for similar items in EconPapers)
Date: 2006
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Citations: View citations in EconPapers (13)

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DOI: 10.1080/14697680600670754

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