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In Rememberance: World Trade Center (WTC)

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Bond Pricing with Default Risk

by Jason C. Hsu of the University of California, Los Angeles,
Jesús Saá-Requejo of Banco Bilbao Vizcaya, and
Pedro Santa-Clara of the University of California, Los Angeles

September 2003

Abstract: We price corporate debt from a structural model of firm default. We assume that the capital market brings about efficient firm default when the continuation value of the firm falls below the value it would have after bankruptcy restructuring. This characterization of default makes the model more tractable and parsimonious than the existing structural models. The model can be applied in conjunction with a broad range of default-free interest rate models to price corporate bonds. Closed-form corporate bond prices are derived for various parametric examples. The term structures of yield spreads and durations predicted by our model are consistent with the empirical literature. We illustrate the empirical performance of the model by pricing selected corporate bonds with varied credit ratings.

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