Pricing Callable Bonds with Stochastic Interest Rate and Stochastic Default Risk: A 3D Finite Difference Model

DefaultRisk.com the web's biggest credit risk modeling resource.

Submit Your Paper

Post Your Résumé

For Recruiters

Today's Featured Book

Structured Products and Related Credit Derivatives: A Comprehensive Guide for Investors
by Brian P. Lancaster, Glenn M. Schultz, Frank J. Fabozzi, Wiley, April 25, 2008, Hardcover, 524 pages

Training Discounted for DefaultRisk.com visitors only:

The Mathematics of Credit Derivatives: The Essential Credit Modelling and Pricing Companion
by Philipp J. Schönbucher,
WBS Training, August 2003, DVD / Interactive CD-ROM

Sponsor:
Shop at Amazon.com and support DefaultRisk.com

Pricing Callable Bonds with Stochastic Interest Rate and Stochastic Default Risk: A 3D Finite Difference Model

by David Wang of Hsuan Chuang University

February 2005

Abstract: This paper presents a 3D model for pricing defaultable bonds with embedded call options. The pricing model incorporates three essential ingredients in the pricing of defaultable bonds: stochastic interest rate, stochastic default risk, and call provision. Both the stochastic interest rate and the stochastic default risk are modeled as a square-root diffusion process. The default risk process is allowed to be correlated with the default-free term structure. The call provision is modeled as a constraint on the value of the bond in the finite difference scheme. This paper can provide new insight for future research on defaultable bond pricing models.

JEL Classification: C00, G13.

Keywords: Defaultable bond, Embedded option, Partial differential equation, Finite difference method.

Books Referenced in this Paper: (what is this?)