A Structural Model of Default Risk

Abstract

The authors price corporate debt from a structural model of firm default. They assume that the capital market brings about efficient firm default when the continuation value of the firm falls below the value it would have after bankruptcy restructuring. This characterization of default makes the model more tractable and parsimonious than the existing structural models. The model can be applied in conjunction with a broad range of default-free interest rate models to price corporate bonds. Closed-form corporate bond prices are derived for various parametric examples. The term structures of yield spreads and durations predicted by this model are consistent with the empirical literature. The authors illustrate the empirical performance of the model by pricing selected corporate bonds with varied credit ratings.

TOPICS: Fixed-income portfolio management, statistical methods, accounting and ratio analysis