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A Binomial Lattice Method for Pricing Corporate Debt and Modeling Chapter 11 Proceedings

Published online by Cambridge University Press:  06 April 2009

Mark Broadie  and
Özgür Kaya
Mark Broadie
Affiliation:
[email protected], Columbia University, Graduate School of Business, 3022 Broadway, New York, NY 10027
Özgür Kaya
Affiliation:
[email protected], Lehman Brothers, 745 Seventh Avenue, New York, NY 10019.
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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.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 42 , Issue 2 , June 2007 , pp. 279 - 312
Copyright
Copyright © School of Business Administration, University of Washington 2007

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