A Defaultable Callable Bond Pricing Model

Investment Management and Financial Innovations, Volume 6, Issue 3, Pages 54-62, 2009.

9 Pages Posted: 21 Mar 2014 Last revised: 5 Sep 2018

See all articles by David Hua

David Hua

Notre Dame de Namur University (NDNU)

Heng-Chih Chou

National Taiwan Ocean University

David K. Wang

National University of Kaohsiung

Abstract

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

Suggested Citation

Hua, David and Chou, Heng-Chih and Wang, David K., A Defaultable Callable Bond Pricing Model. Investment Management and Financial Innovations, Volume 6, Issue 3, Pages 54-62, 2009., Available at SSRN: https://ssrn.com/abstract=2406245

David Hua

Notre Dame de Namur University (NDNU) ( email )

1500 Ralston Avenue
Belmont, CA 94002
United States
(650)508-3678 (Phone)
(650)508-3467 (Fax)

HOME PAGE: http://www.ndnu.edu

Heng-Chih Chou

National Taiwan Ocean University ( email )

2 Bei-Ning Road
Keelung, Taiwan 20224
Taiwan

David K. Wang (Contact Author)

National University of Kaohsiung ( email )

Kaohsiung, 811
Taiwan

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