Pricing Corporate Bonds with Interest Rates Following Double Square-Root Process

HKIMR Working Paper No.11/2016

41 Pages Posted: 20 Jun 2016

See all articles by Chi-Fai Lo

Chi-Fai Lo

The Chinese University of Hong Kong

Cho-Hoi Hui

Hong Kong Monetary Authority - Research Department

Multiple version iconThere are 2 versions of this paper

Date Written: June 20, 2016

Abstract

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

Suggested Citation

Lo, Chi-Fai and Hui, Cho-Hoi, Pricing Corporate Bonds with Interest Rates Following Double Square-Root Process (June 20, 2016). HKIMR Working Paper No.11/2016. Available at SSRN: https://ssrn.com/abstract=2797982 or http://dx.doi.org/10.2139/ssrn.2797982

Chi-Fai Lo

The Chinese University of Hong Kong ( email )

Department of Physics
Shatin, N.T., Hong Kong
China

Cho-Hoi Hui (Contact Author)

Hong Kong Monetary Authority - Research Department ( email )

Hong Kong
China

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