A Simple Approach to Valuing Risky Fixed and Floating Rate Debt and Determining Swap Spreads

Abstract

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. We also use this approach to derive interest-rate swap rates when one or both counter-parties may default. 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.

JEL Classification: G13