A Practical Guide to the Valuation of Coupon-Bearing Fixed Income Securities

A Practical Guide to the Valuation of Coupon-Bearing Fixed Income Securities

01/30/2023 07:22 AM

Robert A. Jarrow and Donald R. van Deventer

• This version: January 24, 2023
• First version: November 21, 2017

Abstract

The purpose of this note is to illustrate the use of modern reduced form models for valuing defaultable coupon-bearing securities like risky sovereign bonds, corporate bonds, and retail loans like auto loans and mortgage loans. We focus on applications, not a review of the literature and not the derivations of the model. Section 1 of this note shows the valuation formulas for the reduced form bond model when there are no liquidity premiums in the marketplace. Section 2 examines three different assumptions about liquidity premiums and shows the implications of liquidity premiums for modeling recovery amounts. Section 3 discusses econometric procedures for deriving recovery rates and the associated liquidity parameters. Section 4 provides recent examples and summarizes related conclusions about implementation of the models using traded bond price data from TRACE.

The evolution of the reduced form bond model implementation techniques has proven that reduced form default probabilities, in combination with the valuation theory, provide greater accuracy in valuation than commonly used market conventions. Superior accuracy in valuation implies superior performance in credit spread generation, hedging, and performance attribution.

The full text of the note is available here:

A Practical Guide to Reduced Form Corporate Bond Valuationv120230124