On a new corporate bond pricing model with potential credit rating change and stochastic interest rate

• Published in: Journal of risk and financial management Vol. 11; no. 4; pp. 1 - 12
• Main Authors: Yin, Hong-Ming, Liang, Jin, Wu, Yuan
• Format: Journal Article
• Language: English
• Published: Basel MDPI 01.12.2018; MDPI AG
• Subjects: Bond ratings; Brownian motion; corporate bond-pricing model; Corporate bonds; Credit ratings; Interest rates; jump volatility; Markov analysis; Mathematical models; multi credit rating migration; Partial differential equations; Securities markets; Sovereign debt; stochastic interest rate; Stochastic models
• ISSN: 1911-8074; 1911-8066; 1911-8074
• DOI: 10.3390/jrfm11040087

In this paper, we consider a new corporate bond-pricing model with credit-rating migration risks and a stochastic interest rate. In the new model, the criterion for rating change is based on a predetermined ratio of the corporation's total asset and debt. Moreover, the rating changes are allowed to happen a finite number of times during the life-span of the bond. The volatility of a corporate bond price may have a jump when a credit rating for the bond is changed. Moreover, the volatility of the bond is also assumed to depend on the interest rate. This new model improves the previous existing bond models in which the rating change is only allowed to occur once with an interest-dependent volatility or multi-ratings with constant interest rate. By using a Feynman-Kac formula, we obtain a free boundary problem. Global existence and uniqueness are established when the interest rate follows a Vasicek's stochastic process. Calibration of the model parameters and some numerical calculations are shown.