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A Two-Factor Hazard Rate Model for PricingRisky Debt and the Term Structure of CreditSpreads

Published online by Cambridge University Press:  06 April 2009

Dilip Madan  and
Haluk Unal
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Abstract

This paper proposes a two-factor hazard rate model, inclosd form, to price risky debt. The likelihood ofdefault is captured by the firm's non-interestsensitive assets and default-free interest rates.The distinguishing features of the model arethreefold. First, the impact of capital structurechanges on credit spreads can be analyzed. Second,the model allows stochastic interest rates to impactcurrent asset values as well as their evolution.Finally, the proposed model is in closed fom,enabling us to undertake comparative staticsanalysis, compute parameter deltas of the model,calibrate empirical credit spreads, and determinehedge positions. Credit spreads generated by ourmodel are consistent with empiricalobservations.

Information

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 35 , Issue 1 , March 2000 , pp. 43 - 65
Copyright
Copyright © School of Business Administration, University of Washington 2000

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Footnotes

*

Both authors, Robert H. Smith school of Business,University of Maryland, College Park, MD 20742.The authors are grateful for the detailed commentsfrom Gurdip Bakshi, Chris James, James Moser,Gordon Phillips, Lemma Senbet, Klaus Toft, AlexTriantis, Xiao Peng Zhang, and Sanjiv Das (thereferee) as well as seminar paticipants at theUniversity of Maryland, Bank Structure Conferenceat the Federal Reserve Bank of Chicago, May 1998,and European Finance Association Meetings inFontainebleau in August 1998, ICBI conference onGlobal Derivatives, Paris, April 1999, TenthAnnual Conference on Financial Economics andAccounting, University of Texas at Austin, October1999, Credit Risk Summit, Risk Conference Londonand New York, October 1999, ICBI Conference onRisk Management Geneva, November 1999, and VIIITor Vergata Financial Conference, University ofRome, December 1999.

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