A Two-Factor Hazard-Rate Model for Pricing Risky Debt and the Term Structure of Credit Spreads

Posted: 19 Apr 2000

See all articles by Dilip B. Madan

Dilip B. Madan

University of Maryland - Robert H. Smith School of Business

Haluk Unal

University of Maryland - Robert H. Smith School of Business

Abstract

This paper proposes a two-factor hazard rate model, in closed form, to price risky debt. The likelihood of default is captured by the firm's non-interest sensitive assets and default-free interest rates. The distinguishing features of the model are threefold. First, the impact of capital structure changes on credit spreads can be analyzed. Second, the model allows stochastic interest rates to impact current asset values as well as their evolution. Finally, the proposed model is in closed form, enabling us to undertake comparative statics analysis, compute parameter deltas of the model, calibrate empirical credit spreads, and determine hedge positions. Credit spreads generated by our model are consistent with empirical observations.

JEL Classification: G12, G13, E43

Suggested Citation

Madan, Dilip B. and Unal, Haluk, A Two-Factor Hazard-Rate Model for Pricing Risky Debt and the Term Structure of Credit Spreads. Available at SSRN: https://ssrn.com/abstract=204629

Dilip B. Madan

University of Maryland - Robert H. Smith School of Business ( email )

College Park, MD 20742-1815
United States
301-405-2127 (Phone)
301-314-9157 (Fax)

Haluk Unal (Contact Author)

University of Maryland - Robert H. Smith School of Business ( email )

College Park, MD 20742-1815
United States
301-405-2256 (Phone)
301-405 0359 (Fax)

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