Pricing Corporate Bonds with Interest Rates Following Double Square-Root Process
HKIMR Working Paper No.11/2016
41 Pages Posted: 20 Jun 2016
Date Written: June 20, 2016
This paper develops a corporate bond pricing model following the structural approach in which the dynamics of the instantaneous risk-free interest rate are governed by a double square-root (DSR) process. Credit spreads generated from this pricing model depend explicitly upon the levels of interest rates via a nonlinear effect arising from a DSR process. Given a positive correlation between interest rates and leverage ratios, the credit spreads generated by this pricing model have a negative relationship with interest rates, that is consistent with empirical findings using bond market data over the period 2008-2013 when interest rates were low.
Keywords: Corporate bond pricing model; Stochastic interest rate; Leverage ratio
JEL Classification: G13, G21, G28
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