Pricing Credit-Sensitive Debt When Interest Rates, Credit Ratings and Credit Spreads Are Stochastic

Abstract:     
This article develops a model for the pricing of credit-sensitive debt contracts. Over the past two decades, the debt markets have seen a proliferation of contracts designed to reapportion interest rate and credit risks between issuer and investors. Contracts including credit-sensitive notes (CSNs), spread adjusted notes (SPANs), and floating rate notes (FRNs) adjust investors' exposures to three risks: interest rate risk, changes in credit risk caused by changes in the credit rating of the issuer of the debt, and changes in credit risk caused by changes in spreads on the debt, even when ratings have not changed. In this article, we develop a pricing model incorporating all three risks, with special emphasis on credit risks. The model incorporates a decomposition of credit spreads into two stochastic elements: the default process and the recovery process in the event of default. The model is easily implementable as it uses observable inputs. By using a discrete time formulation, the model is numerically easy to employ and also permits the pricing of debt with embedded American-type options. It also allows for pricing contracts between parties with varying credit ratings (such as swaps) where each counterparty may have different credit quality. These features impart a degree of generality and practicality to the model, which should make it attractive to academics and practitioners alike.

JEL Classification: G13

Accepted Paper Series