A Two-Factor Hazard-Rate Model for Pricing Risky Debt and the Term Structure of Credit Spreads

Abstract

This paper proposes a two-factor hazard-rate model, in closed-form, to price risky debt. The likelihood of default is captured by the firm's non-interest sensitive assets and default-free interest rates. The distinguishing features of the model are threefold. First, impact of capital structure changes on credit spreads can be analyzed. Second, the model allows stochastic interest rates to impact current asset values as well as their evolution. Finally, the proposed model is in closed form enabling us to undertake comparative statics analysis, compute parameter deltas of the model, calibrate empirical credit spreads and determine hedge positions. Credit spreads generated by our model are consistent with empirical observations.