BFS 2002

Contributed Talk

Valuation of corporate bonds with stochastic default barrier

Chi-fai Lo, C.H. Hui, H.C. Lee

This paper develops a three-factor corporate bond valuation model that incorporates a stochastic default barrier. The default barrier is considered as the bond issuer's liability. A corporate bond defaults when the bond issuer's leverage ratio (liability-to-asset ratio) increases above a predefined default-triggering value. The payoff to the bondholders in case of default is a constant fraction of the value of a default-free security with the same corporate bond face value. A closed-form solution of the corporate bond price is derived to obtain credit spreads. The dynamics of the default barrier proposed in the three-factor model is more general than that proposed by Longstaff and Schwartz (1995) and Sa-Requejo and Santa-Clara (1999). This model is capable of producing quite diverse shapes of the term structures of corporate credit spreads. The numerical results show that credit spreads exhibit complex relationships with the parameters of the model.