A Binomial Lattice Method for Pricing Corporate Debt and Modeling Chapter 11 Proceedings
- 1 June 2007
- journal article
- research article
- Published by Cambridge University Press (CUP) in Journal of Financial and Quantitative Analysis
- Vol. 42 (2), 279-312
- https://doi.org/10.1017/s0022109000003288
Abstract
The pricing of corporate debt is still a challenging and active research area in corporate finance. Starting with Merton (1974), many authors proposed a structural approach in which the value of the assets of the firm is modeled by a stochastic process, and all other variables are derived from this basic process. These structural models have become more complex over time in order to capture more realistic aspects of bankruptcy proceedings. The literature in this area emphasizes closed-form solutions that are derived by either partial differential equation methods or analytical pricing techniques. However, it is not always possible to build a comprehensive model with realistic model features and achieve a closed-form solution at the same time. In this paper, we develop a binomial lattice method that can be used to handle complex structural models such as ones that include Chapter 11 proceedings of the U.S. bankruptcy code. Although lattice methods have been widely used in the option pricing literature, they are relatively new in corporate debt pricing. In particular, the limited liability requirement of the equity holders needs to be handled carefully in this context. Our method can be used to solve the Leland (1994) model and its extension to the finite maturity case, the more complex model of Broadie, Chernov, and Sundaresan (2007), and others.This publication has 17 references indexed in Scilit:
- Optimal Debt and Equity Values in the Presence of Chapter 7 and Chapter 11The Journal of Finance, 2007
- Capital Structure and Asset Prices: Some Effects of Bankruptcy ProceduresThe Journal of Business, 2004
- Liquidation Triggers and the Valuation of Equity and DebtSSRN Electronic Journal, 2003
- Debt Valuation, Renegotiation, and Optimal Dividend PolicyThe Review of Financial Studies, 2000
- American Option Valuation: New Bounds, Approximations, and a Comparison of Existing MethodsThe Review of Financial Studies, 1996
- Design and Valuation of Debt ContractsThe Review of Financial Studies, 1996
- Enhanced Numerical Methods for Options with BarriersCFA Magazine, 1995
- Bumping Up Against the Barrier with the Binomial MethodThe Journal of Derivatives, 1994
- Option pricing: A simplified approachJournal of Financial Economics, 1979
- Corporate Income Taxes, Valuation, and the Problem of Optimal Capital StructureThe Journal of Business, 1978