Pricing Corporate Bonds With Dynamic Default Barriers

Abstract

Merton-type models of pricing corporate bonds based on relatively simple default processes cannot generate credit spreads which replicate empirically observed spreads. This paper presents an analytical valuation model of corporate discount bond prices to address this problem. The main feature of the model is a dynamic default barrier. Different default scenarios can be incorporated into the valuation model through adjusting the default barrier's dynamics. We derive a closed-form solution of the corporate bond price based on the model as a function of the firm value and short-term interest rate, with time-dependent model parameters. The numerical results calculated from the solution show that the model is capable of producing term structures of credit spreads that are consistent with some empirical findings. This model could provide new insight for future research on corporate bond analysis and credit risk modelling.

Keywords: Bond pricing model, Merton model, Default barriers

JEL Classification: G21, G28, G13