Nonhedgeable risk and Credit Risk Pricing

TL;DR

This paper proposes a modified corporate bond pricing model that accounts for non-hedgeable risk by incorporating a replication error term, relaxing liquidity assumptions and ensuring arbitrage-free valuation.

Contribution

It introduces a new model that integrates non-hedgeable risk into bond pricing using a correlated liquid asset, extending the classical Merton framework.

Findings

Model is arbitrage free under mild conditions

Pricing incorporates a compensation for non-hedgeable risk

Framework generalizes classical bond pricing models

Abstract

We introduce a new model for pricing corporate bonds, which is a modification of the classical model of Merton. In this new model, we drop the liquidity assumption of the firm's asset value process, and assume that there is a liquidly traded asset in the market whose value is correlated with the firm's asset value, and all portfolios can be constructed using solely this asset and the money market account. We formulate the market price of the corporate bond as the product of the price of an optimal replicating portfolio and exp(- kappa x replication error), where kappa is a positive constant. The interpretation is that the representative investor accepts the price of the optimal replicating portfolio as a benchmark, however, requests compensation for the non-hedgeable risk. We show that if the replication error is measured relative to the firm's value, the resulting formula is arbitrage free with mild restrictions on the parameters.