Pricing risky corporate debt using default probabilities

We find that a momentum trading strategy can be improved by using the default probabilities that our model proposes. We determine default probabilities by modeling the total assets and liabilities by stochastic differential equations and we define the event of default to occur when total assets are lower than total liabilities. We observe that the bond prices of our model are rather sensitive to the ‘flat’ default rate assumption when compared to actual market prices. Our results provide an indication that the difference between ‘risk-neutral’ and ‘real-world’ default probabilities of a firm is based on the correlation of the asset ratio of that firm with the general market. We also find that the effect of a general market factor is not as influential on every firm as we initially expected.

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