The Valuation of Default Risk in Corporate Bonds and Interest Rate Swaps

Posted: 13 Jun 1998

See all articles by Soren S. Nielsen

Soren S. Nielsen

Technical University of Denmark - Informatics and Mathematical Modeling

Ehud I. Ronn

University of Texas at Austin - Department of Finance

Date Written: February 13, 1996

Abstract

This paper implements a model for the valuation of the default risk implicit in the prices of corporate bonds and interest rate swaps. The analytical approach considers the two essential ingredients in the valuation of corporate bonds: interest rate uncertainty and default risk. The former is modeled as a diffusion process. The latter is modeled as a spread following a diffusion process, with the magnitude of this spread impacting on the probability of a Poisson process governing the arrival of the default event. We apply two variants of this model to the valuation of fixed-for-floating swaps. In the first, the swap is default-free, and the spread represents the appropriate discounted expected value of the instantaneous TED spread; in the second, we allow the swap to incorporate default risk. We test our models using the entire term structure of corporate bond prices for different ratings and industry categories, as well as the term structure of fixed-for-floating swaps.

JEL Classification: G13

Suggested Citation

Nielsen, Soren S. and Ronn, Ehud I., The Valuation of Default Risk in Corporate Bonds and Interest Rate Swaps (February 13, 1996). Available at SSRN: https://ssrn.com/abstract=7247

Soren S. Nielsen

Technical University of Denmark - Informatics and Mathematical Modeling ( email )

Asmussens Alle, Building 305
DK-2300 Lyngby, DE Copenhagen DK-2300
Denmark

Ehud I. Ronn (Contact Author)

University of Texas at Austin - Department of Finance ( email )

Graduate School of Business
Austin, TX 78712
United States
512-471-5853 (Phone)
512-471-5073 (Fax)

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