Shimko, David C., Naohiko Tejima, and Donald van Deventer, "The Pricing of Risky Debt When Interest Rates are Stochastic", Journal of Fixed Income, Vol. 3, No. 2, (September 1993), pp. 58-65.

Abstract: Determination of a corporation's cost of debt capital is an important exercise for both corporate treasurers and bankers. Term structure models have been widely applied to determine the term premium component in bond prices (Vasicek [1977], Cox, Ingersoll, and Ross [1985], Longstaff and Schwartz [1992] represent a short list).

Relatively less academic attention has been paid to the credit component of the cost of capital, however. Option-based models have been applied to corporate debt in order to understand the effects of credit variables on the spread. For example, a pioneering study by Merton [1974] adapts the Black-Scholes option pricing model to the pricing of risky discount debt. In spite of the assumption of a constant interest rate, Merton's model yields important insights into the determinants of the credit spread.

This article generalizes Merton's risky debt pricing model to allow for stochastic interest rates. In this model, we examine the combined effect of term structure variables and credit variables on debt pricing.

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