A Defaultable Callable Bond Pricing Model
Investment Management and Financial Innovations (2009)
9 Pages Posted: 21 Mar 2014 Last revised: 18 Oct 2022
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. The numerical example shows that the 3D model is capable of pricing defaultable bonds with embedded call options adequately. This paper can provide new insight for future research on defaultable bond pricing models.
Keywords: defaultable bond, embedded option, square-root diffusion process, partial differential equation, finite difference method
JEL Classification: C00, G13
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