Pricing Credit-Sensitive Debt When Interest Rates, Credit Ratings and Credit Spreads are Stochastic

J. OF FINANCIAL ENGINEERING, Vol. 5 No. 2

Posted: 12 Feb 1997

See all articles by Sanjiv Ranjan Das

Sanjiv Ranjan Das

Santa Clara University - Leavey School of Business

Peter Tufano

University of Oxford - Said Business School; National Bureau of Economic Research (NBER); University of Oxford - Said Business School

Abstract

This article develops a model for the pricing of credit-sensitive debt contracts. Over the past two decades, the debt markets have seen a proliferation of contracts designed to reapportion interest rate and credit risks between issuer and investors. Contracts including credit-sensitive notes (CSNs), spread adjusted notes (SPANs), and floating rate notes (FRNs) adjust investors' exposures to three risks: interest rate risk, changes in credit risk caused by changes in the credit rating of the issuer of the debt, and changes in credit risk caused by changes in spreads on the debt, even when ratings have not changed. In this article, we develop a pricing model incorporating all three risks, with special emphasis on credit risks. The model incorporates a decomposition of credit spreads into two stochastic elements: the default process and the recovery process in the event of default. The model is easily implementable as it uses observable inputs. By using a discrete time formulation, the model is numerically easy to employ and also permits the pricing of debt with embedded American-type options. It also allows for pricing contracts between parties with varying credit ratings (such as swaps) where each counterparty may have different credit quality. These features impart a degree of generality and practicality to the model, which should make it attractive to academics and practitioners alike.

JEL Classification: G13

Suggested Citation

Das, Sanjiv Ranjan and Tufano, Peter, Pricing Credit-Sensitive Debt When Interest Rates, Credit Ratings and Credit Spreads are Stochastic. J. OF FINANCIAL ENGINEERING, Vol. 5 No. 2. Available at SSRN: https://ssrn.com/abstract=8111

Sanjiv Ranjan Das (Contact Author)

Santa Clara University - Leavey School of Business ( email )

Department of Finance
316M Lucas Hall
Santa Clara, CA 95053
United States

HOME PAGE: http://algo.scu.edu/~sanjivdas/

Peter Tufano

University of Oxford - Said Business School ( email )

Park End Street
Oxford, OX1 1HP
Great Britain
+44 (0) 1865 288551 (Phone)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

University of Oxford - Said Business School ( email )

Park End Street
Oxford, OX1 1HP
Great Britain
+44 (0) 1865 288551 (Phone)

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