A Defaultable Callable Bond Pricing Model: A 3D Finite Difference Approach (original) (raw)

This paper presents a D model for pricing defaultable bonds with embedded call options. The pricing model incorporates three essential ingredients in the pricing of defaultable bonds: stochastic interest rate, stochastic default risk, and call provision. Both the stochastic interest rate and the stochastic default risk are modeled as a square-root diffusion process. The default risk process is allowed to be correlated with the default-free term structure. The call provision is modeled as a constraint on the value of the bond in the finite difference scheme. The numerical example shows that the D model is capable of pricing defaultable bonds with embedded call options adequately. This paper can provide new insight for future research on defaultable bond pricing models. JEL classifications: C00; G13