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Valuation of Risky Debt: a Multi-Period Bayesian Framework

by Leonid V. Philosophov of the Moscow Committee of Bankruptcy Affairs

March 26, 2007

Abstract: The paper describes model of a new type for valuation of risky bonds and loans that we call Bayesian Multi-Period (BMP) model. BMP is neither structural nor reduced form model and not a Merton-type model at all. It considers exact contractual cash flow schedule between lender and borrower and combines it with detailed multi-period prognosis of borrower's default at all stages cash flow process. The prognosis can be based on indices of borrower's current financial position, market factors like "distance to default" or credit spreads as well as on newly proposed indices like a schedule of future paying off a firm's long-term debt. As a result the model calculates "fair" value of a risky debt, "fair" risky yield to maturity, "fair" interest rate on risky bond (at time of issuance), credit loss distribution etc.

The model explains on average about 70% of observed credit spreads.

JEL Classification: C11, C13, C51, E58, G21, G33.

Keywords: Credit risk, Risky bonds, Default prediction, Bond valuation, Bayesian model.

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