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Pricing corporate bonds with interest rates following double square-root process

Author

Listed:
  • Chi-Fai Lo

    (Institute of Theoretical Physics and Department of Physics, The Chinese University of Hong Kong, Shatin, New Territories, Hong Kong SAR, China)

  • Cho-Hoi Hui

    (#x2020;Research Department, Hong Kong Monetary Authority and Hong Kong, Institute for Monetary Research, 55/F, Two International Finance Centre, 8 Finance Street, Central, Hong Kong SAR, China)

Abstract
This paper develops a corporate bond pricing model following the structural approach in which the dynamics of the instantaneous risk-free interest rate is governed by the double square-root (DSR) process. Credit spreads generated from the pricing model depend explicitly upon the levels of interest rates via the non-linear effect arising from the DSR process. Given a positive correlation between the interest rates and leverage ratios, the credit spreads generated by the pricing model have negative relationship with the interest rates, that is consistent with empirical findings using bond market data during 2008–2013 when interest rates were low.

Suggested Citation

  • Chi-Fai Lo & Cho-Hoi Hui, 2016. "Pricing corporate bonds with interest rates following double square-root process," International Journal of Financial Engineering (IJFE), World Scientific Publishing Co. Pte. Ltd., vol. 3(03), pages 1-31, September.
    • Handle: RePEc:wsi:ijfexx:v:03:y:2016:i:03:n:s2424786316500158
    DOI: 10.1142/S2424786316500158
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    References listed on IDEAS

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