Corporate Bond Valuation with Both Expected and Unexpected Default
This paper presents three variants of a tractable structural model in which default may take place both expectedly and unexpectedly. The model has the merit of predicting realistically high short term credit spreads. Closed form solutions are provided for corporate bonds (and default swaps) when interest rates are constant or stochastic and when the bond recovery value is exogenous or endogenous to the model. The analysis suggests that, in order for the observed short term yield spreads on high grade corporate bonds to be compensation for credit risk, bond holders must believe that a dramatic sudden plunge in the firm's assets value is possible, even if extremely unlikely.
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