I recently received the following exercise:

Construct a $n=10$-period binomial model for the short-rate, $r_{i,j}$.

The lattice parameters are:

  • $r_{0,0}=5\%$,
  • $u=1.1$,
  • $d=0.9$ and;
  • $q=1−q=1/2$.

This I did do at this point without any problems.

Assume that the 1-step hazard rate in node $(i,j)$ is given by $H_{i,j}=ab^{j-i/2}$ where $a=0.01$ and $b=1.01$. Compute the price of a zero-coupon bond with face value $F=100$ and recovery $R=20%$.

Now this is a novel part for me as I till now did not price zero-coupon bonds with a default risk.

My question from here is how do I, incorporate the values of the hazard lattice as well as the recovery rate into a zero-coupon bond pricing lattice. (Thus what formula would I use in order to do so correctly)?

  • 1
    $\begingroup$ Hi Noir, to get the best answers to your problem, you should format your question a bit differently. It's a good question, but at first glance, looks just like "how do I do this exercise from start to finish". $\endgroup$ – AfterWorkGuinness Oct 29 '15 at 12:55
  • $\begingroup$ Hey AfterWorkGuinness thanks for the comment, I reworded the last part of the exercise a bit, as I am indeed only interested in the very last step of the exercise. $\endgroup$ – Noir Oct 29 '15 at 13:38
  • $\begingroup$ Your notation is super confusing, can you double check as I think you have errors in the problem statement for example " q=1−q=1/2" I assume you mean p = 1-q and q = 0.5 where p is probability of an up-jump and q is the probability of a down-jump ? $\endgroup$ – AfterWorkGuinness Oct 29 '15 at 18:04
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    $\begingroup$ You should make the notation clearer by not using single letter variables, this will make your question easier to understand and get you an answer faster. $\endgroup$ – AfterWorkGuinness Oct 29 '15 at 18:51
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    $\begingroup$ Your credit-risk text book should have a formula. It's really the normal price - (prob of default * (portfolio - recovery rate)). My notation is informal (I don't have the book with me), but it's really saying getting the probability of default and how much is lost once it defaults. $\endgroup$ – SmallChess Oct 30 '15 at 3:53

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