A Dynamic Programming Approach for the Valuation of Callable Corporate Bonds within the CIR Framework

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A Dynamic Programming Approach for the Valuation of Callable Corporate Bonds within the CIR Framework

by Luca Passalacqua of the Università di Roma La Sapienza

March 21, 2006

Abstract: We show how to price corporate callable (res. putable) bonds in a model where interest rates are described by the Cox, Ingersoll and Ross model and default is described by a stochastic intensity model. Pricing is done by mean of a dynamic programming procedure, recently proposed for non-defaultable bonds, that is shown to be fast and accurate. The procedure is easy to implement and constitute an alternative to the use of similar precision but more elaborate difference elements methods. The interplay between default and callability is also discussed in the case of European options where closed form solutions are available.

JEL Classification: G12, G13.

Keywords: Callable Bonds, CIR model, Credit Risk.

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