Pricing Corporate Bonds with Dynamic Default Barriers

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Pricing Corporate Bonds with Dynamic Default Barriers

by Cho-Hoi Hui of the Hong Kong Monetary Authority,
Chi-Fai Lo of the Chinese University of Hong Kong, and
Shun-Wai Tsang of the Chinese University of Hong Kong

Spring 2003

Abstract: Merton-type models of pricing corporate bonds based on relatively simple default processes cannot generate credit spreads which replicate empirically observed spreads. This article presents an analytical valuation model of corporate discount bond prices to address this problem. The main feature of the model is a dynamic default barrier. Different default scenarios can be incorporated into the valuation model through adjusting the default barrier's dynamics. We derive a closed-form solution of the corporate bond price based on the model as a function of the firm value and short-term interest rate, with time-dependent model parameters. The numerical results calculated from the solution show that the model is capable of producing term structures of credit spreads that are consistent with some empirical findings. This model could provide new insight for future research on corporate bond analysis and credit risk modeling.

JEL Classification: G21, G28, G13.

Keywords: Corporate Bond Pricing, Credit Risk, Default Barriers.

Published in: Journal of Risk, Vol. 5, No. 3, (Spring 2003), pp. 17-37.

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