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A Simple Approach to Valuing Risky Fixed and Floating Rate Debt
Author(s) -
LONGSTAFF FRANCIS A.,
SCHWARTZ EDUARDO S.
Publication year - 1995
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/j.1540-6261.1995.tb04037.x
Subject(s) - corporate debt , interest rate , debt , economics , bond , econometrics , valuation (finance) , credit spread (options) , simple (philosophy) , corporate bond , financial economics , credit risk , default risk , monetary economics , interest rate risk , actuarial science , accounting , finance , philosophy , epistemology
We develop a simple approach to valuing risky corporate debt that incorporates both default and interest rate risk. We use this approach to derive simple closed‐form valuation expressions for fixed and floating rate debt. The model provides a number of interesting new insights about pricing and hedging corporate debt securities. For example, we find that the correlation between default risk and the interest rate has a significant effect on the properties of the credit spread. Using Moody's corporate bond yield data, we find that credit spreads are negatively related to interest rates and that durations of risky bonds depend on the correlation with interest rates. This empirical evidence is consistent with the implications of the valuation model.