Reportgreen1997

Default Risk and the Effective Duration of Bonds

44 citations0/0 files storedWorld Bank policy research working paper

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Credit Risk and Financial Regulations Stochastic processes and financial applications Risk Management in Financial Firms

Abstract

Default risk creates difficulties for fixed-income portfolio managers in measuring a portfolio's exposure to interest rate risk. It also heightens the anxiety of traders and arbitragers who are hedging their investments, and it compounds financial institutions' problem of matching assets and liabilities. The consensus among researchers is that credit risk shortens the effective duration of corporate bonds. This paper provides estimates of how much shorter durations become because of credit risk. These estimates are based on observable data and easily estimated bond pricing parameters. Because the duration measures are taken with respect to movements in a common reference rate of interest, they can be used with greater confidence than can other measures when attempting to compute the duration of a portfolio of bonds subject to varying degrees of credit risk.

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References

1974ON THE PRICING OF CORPORATE DEBT: THE RISK STRUCTURE OF INTEREST RATES*1996Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads 1995Pricing Derivatives on Financial Securities Subject to Credit Risk 1977The Valuation of Corporate Liabilities as Compound Options 1989Measuring Corporate Bond Mortality and Performance 1993Does Default Risk in Coupons Affect the Valuation of Corporate Bonds?: A Contingent Claims Model 1994Using Default Rates to Model the Term Structure of Credit Risk 1977Bankruptcy, absolute priority, and the pricing of risky debt claims

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