Pricing credit-risky bonds using recovery rate uncertainty and macro-regime switching

• Published in: The European journal of finance 2024, Vol.30 (2), p.127-143
• Main Authors: Chen, Son-Nan, Hsu, Pao-Peng, Liang, Kuo-Yuan
• Format: Article
• Language: English
• Subjects: a two-factor hazard rate model; Business cycles; credit cycle; Credit ratings; Credit-risky bond; Endogenous; Recovery; regime-switching; stochastic recovery rate; Uncertainty
• ISSN: 1351-847X; 1466-4364
• DOI: 10.1080/1351847X.2023.2193703

A proposed model is used to account for both the recovery rate and regime-switching uncertainties for pricing credit-risky bonds. A two-factor hazard rate model (TFHRM) is also considered, where the dynamics of both instantaneous forward rates and asset values are modeled using Markov-modulated geometric Brownian motions (MMGBMs). Moreover, a macroeconomic factor is incorporated into the MMGBMs. The model complexity is resolved through the introduction of an endogenous intensity function and a recovery rate under the TFHRM. A semi-closed-form solution for pricing defaultable bonds is derived along with a pricing formula for credit spread. A credit cycle is constructed to reflect changes in industry characteristics and macroeconomic factors. The empirical study demonstrates that the inclusion of a stochastic recovery rate increases the model's pricing accuracy, and the results indicate a close interaction among business cycles, recovery rates, and credit ratings.