A Simple Approach to Valuing Risky Fixed and Floating Rate Debt

Authors

  • FRANCIS A. LONGSTAFF,

  • EDUARDO S. SCHWARTZ

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    • Both authors are from the Anderson Graduate School of Management, University of California at Los Angeles. This is a substantially revised version of an earlier working paper entitled “Valuing Risky Debt: A New Approach.” We are grateful for the comments and suggestions of Brian Betker, Brad Cornell, Darrell Duffie, Julian Franks, Mark Grinblatt, Robert Heinkel, David Hirshleifer, Hayne Leland, Andrew Lo, Victor Makarov, Richard Rendleman, Ehud Ronn, Mark Rubinstein, Chester Spatt, Walter Torous, Bruce Tuckman, Justin Wood, Josef Zechner, and seminar participants at the Amex Options and Derivatives Colloquium, the University of British Columbia, the University of California at Berkeley, Duke University, the European Institute for Financial Analysis and Portfolio Management, the University of Rochester, Southern Methodist University, Stanford University, the University of Strathclyde, Texas Christian University, UCLA, and the European Finance Association and Western Finance Association meetings. We are particularly grateful for generous financial support by the Milken Institute for Job and Capital Formation. All errors are our responsibility.

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. 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.

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