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A Two-Factor Hazard Rate Model for Pricing Risky Debt and the Term Structure of Credit Spreads

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, in closd form, to price risky debt. The likelihood of default is captured by the firm's non-interest sensitive assets and default-free interest rates. The distinguishing features of the model are threefold. First, the impact of capital structure changes on credit spreads can be analyzed. Second, the model allows stochastic interest rates to impact current asset values as well as their evolution. Finally, the proposed model is in closed fom, enabling us to undertake comparative statics analysis, compute parameter deltas of the model, calibrate empirical credit spreads, and determine hedge positions. Credit spreads generated by our model are consistent with empirical observations.

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 comments from Gurdip Bakshi, Chris James, James Moser, Gordon Phillips, Lemma Senbet, Klaus Toft, Alex Triantis, Xiao Peng Zhang, and Sanjiv Das (the referee) as well as seminar paticipants at the University of Maryland, Bank Structure Conference at the Federal Reserve Bank of Chicago, May 1998, and European Finance Association Meetings in Fontainebleau in August 1998, ICBI conference on Global Derivatives, Paris, April 1999, Tenth Annual Conference on Financial Economics and Accounting, University of Texas at Austin, October 1999, Credit Risk Summit, Risk Conference London and New York, October 1999, ICBI Conference on Risk Management Geneva, November 1999, and VIII Tor Vergata Financial Conference, University of Rome, December 1999.

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