Valuation Model of Defaultable Bond Values in Emerging Markets

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

June 2002

Abstract: This paper develops a model to value defaultable bonds in emerging markets. Default occurs when some signaling process hits a pre-defined default barrier. The signaling variable is considered to be some macro-economic variables such as foreign exchange rates. The dynamics of the default barrier depends on the volatility and the drift of the signaling variable. We derive a closed-form solution of the defaultable bond price from the model as a function of a signaling variable and a short-term interest rate. The numerical results show that the model values generated by using foreign exchange rates as the signaling variables can broadly track the market credit spreads of defaultable bonds in South Korea and Brazil. Given an expected level of the foreign exchange rate, defaultable bond values under stressed market situation can be obtained.

JEL Classification: G21, G28, G13.

Keywords: risky bonds, credit risk, emerging markets, stress tests.

Published in: Asia-Pacific Financial Markets, (March 2002), Vol. 9, No. 2, pp. 45-60.

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