Pricing Credit-Sensitive Debt When Interest Rates, Credit Ratings and Credit Spreads are Stochastic

Abstract

This paper develops a model for the pricing of creditsensitive debt contracts Over the past two decades the debt markets have seen a proliferation of contracts designed to reapportion interest rate and credit risks between issuer and investors Contracts including creditsensitive notes CSNs spread adjusted notes SPANs and oating rate notes FRNs adjust investors exposures to three risks interest rate risk changes in credit risk caused by changes in the credit rating of the issuer of the debt and changes in credit risk caused by changes in spreads on the debt even when ratings have not changed In the paper we develop a pricingmodel incorporating all three risks with special emphasis on credit risks The model incorporates a decomposition of credit spreads into two stochastic elements the default process and the recovery process in the event of default The model is easily implementable as it uses observable inputs By using a discrete time formulation the model is numerically easy to employ and also permits the pricing of debt with embedded options of American type It also allows for pricing contracts between parties with varying credit ratings such as swaps where each counterparty may have dierent credit quality These features impart a degree of generality and practicality to the model which should make it attractive to academics and practitioners alike

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