I. I ntroduction T he value of a particular issue of corporate debt depends essentially on three items: (1) the required rate of return on riskless (in terms of default) debt (e.g., government bonds or very high grade corporate bonds); (2) the various provisions and restrictions contained in the indenture (e.g., maturity date, coupon rate, call terms, seniority in the event of default, sinking fund, etc.); (3) the probability that the firm will be unable to satisfy some or all of the indenture requirements (i.e., the probability of default). While a number of theories and empirical studies has been published on the term structure of interest rates (item 1), there has been no systematic development of a theory for pricing bonds when there is a significant probability of default. The purpose of this paper is to present such a theory which might be called a theory of the risk structure of interest rates. The use of the term “risk” is restricted to the possible gains or losses to bondholders as a result of (unanticipated) changes in the probability of default and does not include the gains or losses inherent to all bonds caused by (unanticipated) changes in interest
The Journal of Finance – Wiley
Published: May 1, 1974
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