TAILIEUCHUNG - The Pricing of Options on Credit-Sensitive Bonds

We build a three-factor term-structure of interest rates model and use it to price corporate bonds. The first two factors allow the risk-free term structure to shift and tilt. The third factor generates a stochastic credit-risk premium. To implement the model, we apply the Peterson and Stapleton (2002) diffusion approximation methodology. The method approximates a correlated and lagged-dependent lognormal diffusion processes. We then price options on credit-sensitive bonds. The recombining log-binomial tree methodology allows the rapid computation of bond and option prices for binomial trees with up to forty periods | The Pricing of Options on Credit-Sensitive Bonds Sandra Peterson1 Richard C. Stapleton2 April 11 2003 1 Scottish Institute for Research in Investment and Finance Strathclyde University Glasgow UK. Tel 44 141-548-4958 e-mail 2Department of Accounting and Finance Strathclyde University Glasgow UK and University of Melbourne Australia. Tel 44 1524-381172 Fax 44 524 846 874 e mail dj@ Abstract The Pricing of Options on Credit-Sensitive Bonds We build a three-factor term-structure of interest rates model and use it to price corporate bonds. The first two factors allow the risk-free term structure to shift and tilt. The third factor generates a stochastic credit-risk premium. To implement the model we apply the Peterson and Stapleton 2002 diffusion approximation methodology. The method approximates a correlated and lagged-dependent lognormal diffusion processes. We then price options on credit-sensitive bonds. The recombining log-binomial tree methodology allows the rapid computation of bond and option prices for binomial trees with up to forty periods. Model for Pricing Options on Credit-Sensitive Bonds 1 1 Introduction The pricing of credit-sensitive bonds that is bonds which have a significant probability of default is an issue of increasing academic and practical importance. The recent practice in financial markets has been to issue high yield corporate bonds that are a hybrid of equity and risk-free debt. Also to an extent most corporate bonds are credit-sensitive instruments simply because of the limited liability of the issuing enterprise. In this paper we suggest and implement a model for the pricing of options on credit-sensitive bonds. For example the model can be used to price call provisions on bonds options to issue bonds and yield-spread options. From a modelling point of view the problem is interesting because it involves at least three stochastic variables at least two factors are required to capture shifts and

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