RT Journal Article
SR Electronic
T1 A Three-Factor Defaultable Term Structure Model
JF The Journal of Fixed Income
FD Institutional Investor Journals
SP 63
OP 79
DO 10.3905/jfi.2000.319265
VO 10
IS 2
A1 Bernd Schmid
A1 Rudi Zagst
YR 2000
UL https://pm-research.com/content/10/2/63.abstract
AB This article develops a three-factor defaultable term structure model for the pricing of a wide range of risky debt contracts and derivatives. One of the factors that determine the credit spread is the so-called uncertainty process, which can be understood as an aggregation of all information currently available on the quality of the firm. The authors assume that the spread between a defaultable and a non-defaultable bond is driven to a considerable extent by the uncertainty index, but also that contractual provisions, liquidity, and the premium demanded in the market for similar instruments have a great impact on credit spreads. Credit spreads can be easily related to business cycles by replacing the uncertainty index by some index of macroeconomic variables without any change of the theoretical framework. The analytical solution obtained for defaultable bonds can be implemented easily in practice, as all the variables and parameters can be inferred from market data. The authors demonstrate application of the model to the pricing of a variety of default-related instruments such as credit derivatives.