The Pricing of Options on Credit-Sensitive Bonds

16 Pages Posted: 3 Jun 2004

See all articles by Sandra Peterson

Sandra Peterson

affiliation not provided to SSRN

Richard C. Stapleton

University of Strathclyde - Department of Accounting and Finance

Abstract

We build a three-factor term-structure of interest rates model and use it to price corporate bonds. The first two factors allow the risk-free term structure to shift and tilt. The third factor generates a stochastic credit-risk premium. To implement the model, we apply the Peterson and Stapleton (2002) diffusion approximation methodology. The method approximates a correlated and lagged-dependent lognormal diffusion processes. We then price options on credit-sensitive bonds. The recombining log-binomial tree methodology allows the rapid computation of bond and option prices for binomial trees with up to forty periods.

Keywords: Credit Risk, Bonds, Options

JEL Classification: G12, G13

Suggested Citation

Peterson, Sandra and Stapleton, Richard C., The Pricing of Options on Credit-Sensitive Bonds. Schmalenbach Business Review, Vol. 55, July 2003. Available at SSRN: https://ssrn.com/abstract=550702

Sandra Peterson

affiliation not provided to SSRN

Richard C. Stapleton (Contact Author)

University of Strathclyde - Department of Accounting and Finance ( email )

Curran Building
100 Cathedral Street
Glasgow G4 0LN
United Kingdom
+44 1524 381 172 (Phone)
+44 1524 846874 (Fax)

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