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Pricing Bonds and Bond Options with Default Risk

Author

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  • Emilio Barone
  • Giovanni Barone‐Adesi
  • Antonio Castagna

Abstract

The pricing of bonds and bond options with default risk is analysed in the general equilibrium model of Cox, Ingersoll, and Ross (1985). This model is extended by means of an additional parameter in order to deal with financial and credit risk simultaneously. The estimation of such a parameter, which can be considered as the market equivalent of an agencies' bond rating, allows to extract from current quotes the market perceptions of firm's credit risk. The general pricing model for defaultable zero‐coupon bond is first derived in a simple discrete‐time setting and then in continuous‐time. The availability of an integrated model allows for the pricing of default‐free options written on defaultable bonds and of vulnerable options written either on default‐free bonds or defaultable bonds. A comparison between our results and those given by Jarrow and Turnbull (1995) is also presented.

Suggested Citation

  • Emilio Barone & Giovanni Barone‐Adesi & Antonio Castagna, 1998. "Pricing Bonds and Bond Options with Default Risk," European Financial Management, European Financial Management Association, vol. 4(2), pages 231-282, July.
    • Handle: RePEc:bla:eufman:v:4:y:1998:i:2:p:231-282
    DOI: 10.1111/1468-036X.00065
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    Cited by:

    1. Pascal François & Sophie Pardo, 2015. "Prepayment risk on callable bonds: theory and test," Decisions in Economics and Finance, Springer;Associazione per la Matematica, vol. 38(2), pages 147-176, October.

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