A Default Risk Model Under Macroeconomic Conditions

24 Pages Posted: 1 Sep 2012 Last revised: 27 Feb 2013

See all articles by Weiping Li

Weiping Li

Civil Aviation Flight University of China ; Oklahoma State University

Date Written: August 31, 2012

Abstract

This paper presents a structural model of default risk under macroeconomic conditions. The macroeconomic conditions are assumed to be a finite state of a Markov chain. The innovation of our model is to characterize the firm default, the default-free pure discount bond price, the defaultable bond price and the credit spread associated with macroeconomic conditions. By using the Wiener-Hopf factorization, we show that there is a risk-neutral measure under regime-switching. Under macroeconomic conditions, we derive both the default-free bond price and the price of defaultable bond governed by fundamental systems of partial differential equations. Both the defaultable yield-to-maturity, the credit spread and the duration are related to the finite state of the Markov chain.

Keywords: Macroeconomic Conditions, Markov Chain, defaultable bond, term structure of interest rate, default trigger, fundamental system of PDE's

Suggested Citation

Li, Weiping, A Default Risk Model Under Macroeconomic Conditions (August 31, 2012). Midwest Finance Association 2013 Annual Meeting Paper, Available at SSRN: https://ssrn.com/abstract=2139596 or http://dx.doi.org/10.2139/ssrn.2139596

Weiping Li (Contact Author)

Civil Aviation Flight University of China ( email )

46 Nanchang road
Guanghan, Sichuan 618307
China

Oklahoma State University ( email )

Stillwater, OK
United States

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