Bond Pricing with Default Risk

Jesus Saa-Requejo and Pedro Santa-Clara

University of California at Los Angeles, Anderson Graduate School of Management from Anderson Graduate School of Management, UCLA

Abstract: We offer a new model for pricing bonds subject to default risk. The event of default is remodeled as the first time that a state variable that captures the solvency of the issue goes below a certain level. The payoff to the bond in case of default is a constant fraction of the value of a security with the same promised payoffs but without the risk of default. We show that our model is very tractable under different models of interest rate risk and of the interaction between default risk and interest rate risk, with closed-form solutions for corporate bond prices in special cases. The model is seen to produce term structures of default yield spreads and forward spreads with more reasonable properties than other models that have recently been proposed. We illustrate the issue of our model by estimating its parameters and backing up both the default writedown and the state variable that governs default risk from a panel data set of bond prices issued by RJR Nabisco.

Date: 1997-03-23
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Citations: View citations in EconPapers (10)

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Working Paper: Bond Pricing with Default Risk (2003)
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