How Do You Price a Bond with Default Risk and Continuous Trading?

[rukimaru]

Hi!

Just wondering if anyone could help with this question:

"now price a bond that is of a 4 year maturity and if it defaults in year t+k incurs a loss of 20%, but it does not terminate, and continues to be traded up to and including the fourth year"

as I understand this is a defaultable bond pricing question; but the formula calls for the probabilities?

I do not want an answer but, could someone point me in the direction of the topic to read or maybe some helpful information?

Thank you in advance!

 

[jvicens]

Hi there,

Thank you for your question. You are correct, this is a defaultable bond pricing question. In order to price a defaultable bond, you will need to use a credit risk model that takes into account the probability of default and the expected loss in the event of default.

There are several approaches to pricing defaultable bonds, including the structural model and the reduced-form model. The structural model assumes that the value of a company's assets and liabilities can be used to determine the probability of default. On the other hand, the reduced-form model uses historical default data to estimate the probability of default.

I recommend doing some further research on these models and their respective formulas to gain a better understanding of how to price a defaultable bond. Additionally, you can also look into credit risk metrics such as credit spreads and credit ratings, which can also impact the pricing of a defaultable bond.

I hope this helps guide you in the right direction. Best of luck with your research!