Pricing of Corporate Straight Bonds with Recovery Rate

Abstract

In recent years, direct financing such as bond issuing has become common to many Japanese firms. The pricing method for the corporate bond differs from that for risk free bonds such as JGB, since corporate bonds incorporate credit risk. On default, none or only a part of principal and interest is paid to bond holders. So, it is necessary to evaluate the credit risk when investors price bonds which embed credit risk. The use of credit rating to evaluate credit risk is quite popular with many researchers. The pioneering paper by Jarrow et al.(1997) models the probability of credit rating change as a Markov chain. They make possible the pricing of corporate bonds using the following procedure. First they define martingale default probability, and then calibrate the martingale default probability to bond price. In their paper, they give the recovery rate at the default endogeneously. But in Japanese bond markets, issue of corporate bond was rare until quite recently. So, few defaults have been observed and statistical parameter estimation is quite difficult. In this paper, we propose a procedure to estimate the recovery rate. Then we conduct an empirical study in Japanese bond market and show some findings.