Longstaff Schwartz (95) Risky Debt (P)

Formulas in Longstaff & Schwartz 1995 for Risky Debt
Source:
Longstaff, Francis A., Schwartz, Eduardo S. A simple approach to Valuing Risky Fixed and Floating Rate Debt. Journal of
Finance. Vol 3. July 1995.
Vasicek, O. 1977 "An Equilibrium Characterization of the term structure." Journal of Financial Economics 5: 177-188.
Firm asset value process: with parameters
dV =μVdt+σ VdZ 1 V: firm asset value

m: drift rate of asset process
Interest rate process: r: short-term riskless interest rate
dr= ( ζ−βr ) dt +ηdZ 2

s: instanteaneous stdev of asset process (constant)
z: long-term equilibrium of mean reverting process (constant)
b: "pull-back" factor - speed of adjustment (constant)
h: spot rate volatility (constant)
Value of risky discount bond: dZ1,2 standard Wiener processes with correlation rdt
K: Bankruptcy threshold - financial distress if V falls below K
X: ratio of V/K - firm asset value as % of bankruptcy threshold
P(X,r,T)=D(r,T)−wD ( r,T ) Q ( X ,r,T ) a: z plus constant (c) to represent market price of risk
T: time to maturity
w: writedown = 1 - recovery rate
D(r,T) is the value of riskfree (no credit risk) discount bond according to Vasicek (1977).
A (T )−B(T )r )
D(r ,T )=e
with 2 2 2
η α η α ( e−βT −1 ) − η
A ( T )= ( 2β
2− β ) (
T+
β
3−
β
2 ) ( 4β
3 )( −2 βT
e −1 )
1−e−βT
B (T )=
α
Q(X,r,T) term can be interpreted as probability - under risk neutral measure - that default occurs.
n
q1 =N ( a1 )
Q( X , r , T , n )=∑ qi i−1
i=1
qi =N ( ai )− ∑ q j N ( bij ) , i=2,3 ,. . . .. , n
j=1
N(.) denotes the cumulative standard normal distribution
with
−ln X −M (iT /n , T ) M ( jT /n , T )− M ( iT /n , T )
ai = bij =
√ S (iT /n ) √ S ( iT /n )−S ( jT /n )
α − ρση η2 σ2
M ( t , T )= ( β
− 2−
β 2
t )
ρση η2
+ 2 +
β (2β
3 exp − βT ( exp βt −1 )
( ) ( )
)
r α η2
+
( β
− 2 + 3 ( 1−exp (− βt ) )
β β )
η2
− ( 2 β3 )
exp (− βT ) ( 1−exp (− βt ) )
ρση η2
S ( T )= ( β
+ 2 + σ2 t
β )
ρση 2 η2
(
− 2 + 3
β β )( 1− exp (− βt ) )
η2
+
( )(
2 β3
1− exp (− 2 βt ) )
Kurt Hess, kurthess@waikato.ac.nz 11/02/2021 25891234.xls Formulas

Risky Debt Valuation Model Longstaff & Schwartz 95
Notation L&S 95 Risky Discount Bond Prices as a
Rate r0 at t=0 r 7.0% 14
1.0
Maturity time (years) T 2.0 20
0.9
"Pullback" b 1.00 100
0.8
Instantaneous StDev. of short rate h 3.162%
0.7
h 2
0.0010 10
0.6
a in L&S = z + constant a 0.060 60
V/K =X X 1.10 110
0.5
Writedown = 1 - Recovery Rate w 0.50 50 0.4
Volatility of asset value process s 20.00% 0.3
s2 0.0400 40 0.2
Instantaneous correl. Asset/interest rate r - 0.25 75 0.1
Iterations for Q n 10 -
Risky Discount Bond 0 2 Time
Value risk free discount bond (Vasicek) D #VALUE! #VALUE!
Yield riskfree bond #VALUE! #VALUE!
Probability of default (risk neutral) Q #VALUE!
Value risky discount bond (L&S 95) P #VALUE! #VALUE!
Yield risky discount bond #VALUE! #VALUE! Term Structure of Interest Risky
8%
Floating-rate Coupon Payment
Time of floating rate payment (<=T) t 2.0 set to T (testing) 7%
Expected value r at t (risk neutral process) R #VALUE!
6%
Correlation adjustment G #VALUE!
Value of floating rate payment at time tau F #VALUE! 5%
Values of floating-rate coupon payments (for T=t) 4%

8.0% Value of floating 3%
rate payment at
6.0% 2%
time tau
r at t=0 1%
4.0%
0%
2.0% 0 2 Time to mat
4
0.0%
0 2 Time to maturity
4 6 8 10 12
Discount Bond Prices as a function of bond tenor (time to maturity)
Value risky discount bond

(L&S 95)
Value risk free discount
bond (Vasicek)
0 2 Time to 4maturity 6 8 10 12
Structure of Interest Risky Discount Bonds
Floating-rate
Coupon
Payment
Column X
r at t=0
Yield riskfree
bond
0 2 Time to maturity
4 6 8 10 12
Data Table
#VALUE! #VALUE! #VALUE!
0.01 #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
0.75 #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! r at t=0
1 #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! 0 7.00%
2 #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
List of iterations for q
1
2
5
10
20
50
100
200
500
1000
Risky Coupon Debt Model Longstaff & Schwartz 95
Notation L&S 95 Risky Coupon Bond Prices a
Rate r0 at t=0 r 4.0% 8
12.00
Maturity time (years) T 2.0 20
"Pullback" b 1.00 100 10.00
Instantaneous StDev. of short rate h 3.162%
h2 0.0010 10 8.00
a in L&S = z + constant a 0.060 60
V/K =X X 1.50 150 6.00
Writedown = 1 - Recovery Rate w 0.50 50
Volatility of asset value process s 20.00% 4.00
s2 0.0400 40
2.00
Instantaneous correl. Asset/interest rate r - 0.25 75
Iterations for Q n 10 -
0 1 2 Tim
Risky Coupon Bond
Fixed coupon 8.00% 32
Risky (clean price) #VALUE! Yield Curve Risky vs. Risk
Risky (incl. accrued interest) #VALUE!
Yield to Maturity Risky Bond #VALUE! 5%
Riskless Coupon Bond
Riskless coupon bond (sigma=0) #VALUE! 4%
Riskless (incl. accrued interest) #VALUE!
Yield to Maturity Riskless Bond #VALUE! 4%
Credit Spread (in bps) #VALUE!
3%
Credit Spread (in bps) 3%
12 2%
10
2%
8
6 1%
4
1%
2
- 0%
0 2 Time to4maturity 6 8 10 12 0 1 2Time
Formulas in Longstaff & Schwartz 1995 for risky debt
Source:
Longstaff, Francis A., Schwartz, Eduardo S. A simple approach to Valuing Risky Fixed and Floating Rate Debt. Journal of
Firm asset value process:
dV =μ Vdt +σ VdZ 1
Interest rate process:
dV =μ Vdt +σ VdZ 1
dr= ( ζ−βr ) dt +η dZ 2
Value of risky discount bond:
P(X ,r,T )=D(r,T )−wD ( r,T ) Q ( X ,r,T )
Testing
#VALUE!
5%
#VALUE!
0.1 0.045 0.0447755616

0.6 0.045 0.043670049
1.1 1.145 1.0837254944
1.172171105
Coupon Bond Prices as a function of bond maturity
Risky (clean price)

Risky (incl. accrued interest)
Riskless coupon bond (sigma=0)
Riskless (incl. accrued interest)
0 1 2 Time3to maturity
4 5 6 7 8 9 10
Curve Risky vs. Riskless Coupon Bonds
Yield to Maturity Risky Bond

Yield to Maturity Riskless Bond
r at t=0
0 1 2Time to3 maturity

4 5 6 7 8 9 10
ing Rate Debt. Journal of Finance. Vol 3. July 1995.

with parameters
V: firm asset value
m: drift rate of asset process
r: short-term riskless interest rate
s: instanteaneous stdev of asset process (constant)
z: long-term equilibrium of mean reverting process (constant)
b: "pull-back" factor - speed of adjustment (constant)
h: spot rate volatility (constant)
dZ1,2 standard Wiener processes with correlation rdt
X: ratio of V/K - firm asset value as % of bankruptcy threshold

a: z plus constant (c) to represent market price of risk
TABLE 1 TABLE 2
Data Table Risky Clea Risky Dirty Riskless C Riskless Dirty
#VALUE! #VALUE! #VALUE! #VALUE!
0.001 #VALUE! #VALUE! #VALUE! #VALUE! 0.001
1 #VALUE! #VALUE! #VALUE! #VALUE! 0.1
4 #VALUE! #VALUE! #VALUE! #VALUE! 1
5.01 #VALUE! #VALUE! #VALUE! #VALUE! 3
9.01 #VALUE! #VALUE! #VALUE! #VALUE!
10 #VALUE! #VALUE! #VALUE! #VALUE!
List of iterations for q

1
2
5
10
20
50
100
200
500
1000
r at t=0
0 4.00%
YTM Risky YTM Riskless Spread
#VALUE! #VALUE!
Term structure in Vasicek Model
Hull L&S 95 Vasicec Term Structure
Running time t n.a. 0 9%
Rate r0 at t=0 r0 r 8.0% 16 8%
Maturity time (T) T 7 2.0 20
7%
"Pullback" a b 0.07 7
6%
Long-run equilibrium b n.a. 8.0% 80
Instanteanous StDev. of short rate s h 2.0% 20 5%
Market Price of Interest Rate Risk l n.a. 0.0% 0 4%

Constant in L&S a - z== c = s * l = s x l c 0.00E+00
3%
a*b z 0.0056
a in L&S = c + l in Hull a 0.0056 2%
1%
Results:
0%
B in Vasicek Model (Hull) 1.87
0 5Time to10
A in Vasicek Model (Hull) 0.989838 -0.010214 0.0391837
Infinitely-long Rate (Y¥) 3.92%
Vasicek Discount Factor 0.852554 #VALUE! #VALUE!
Vasicek Zero Rate 7.976%
Vasicec Discount Function

1.0
0.9 Vasicek Discount
Factor
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
-
0 5 Time10
to maturity15 20 25 30 35
Formulas in Longstaff & Schwartz for Vasicek Model
Interest rate process: dr= ( ζ−βr ) dt +η dZ 2

Value of zero=coupon bond:
A (T )−B( T )r )
D(r ,T )=e
with
1−e−βT
B (T )=
β
2 2 2
η α η α η
A ( T )=
( 2β
2− β ) (
T+
β
3−
β
2 ) (e −βT
−1 ) −
( 4β
3 ) ( e−2 βT −1
2 2 2
η α η α η
A ( T )=
( 2β
2− β ) (
T+
β
3−
β
2 ) (e −βT
−1 ) −
( 4β
3 ) ( e−2 βT −1
Source:
Longstaff, Francis A., Schwartz, Eduardo S. A simple approach to Valuing Risky Fixed and Floating Rate Debt. Journal of F
Hull, John C., Options, Futures & Other Derivatives. Fourth edition (2000). Prentice-Hall. p. 567.
Model: Vasicek, O. 1977 "An Equilibrium Characterization of the term structure." Journal of Financial Economics 5: 177-18
η2 α η2 α η2
A ( T )=
( 2β
2− β ) (T+
β
3−
β
2 )( −βT
e −1 ) −
( 4β
3
L&S 95 Vasicek translated to Hull notation:
σ2 c σ2 b c σ2
A ( T )=
( 2 a2
− b−
a ) (
T+
a3
−
a
−
a2
(e ) −aT
−1 ) −
( 4
Formula in Hull p. 567. The following transformations prove that A(T) is the same in Hull and L&S 95
2
σ
)( )
2
a b− 2
1− e−aT 2 σ 2 ( 1−e−aT )
A ( T )=
a ( −T
a2
−
4 a3
2 −aT −2 aT
2 a2 b−σ 2 2 a2 b−σ 2 ( σ ( 1−2 e +e )
A (T )=−
2a (
2) ( )
T+
2a 3
−aT
1−e − )
4 a3
2 −2 aT
σ2 b σ2
−aT
σ ( 1−2 e + e )
A (T )=
2 a2( ) ( )(
−b T + −
a 2 a3
1−e−aT
)−
4 a3
σ2 σ 2 b −aT σ 2 −aT σ 2 σ 2 e−aT σ 2 e−2 aT
2a ( ) ( )( )
A (T )= 2 −b T + 3 − e −1 − 3 ( e −1 )− 3 + 3 −
a a 2a 4 a 2a 4a3
σ2 σ 2 b −aT σ 2 e−aT σ 2 σ 2 σ 2 e−aT σ 2 e−2 aT
2a ( ) ( )( )
A (T )= 2 −b T + 3 − e −1 − 3 + 3 − 3 + 3 −
a a 2a 2a 4a 2a 4a3
σ2 σ 2 b −aT σ 2 −2 aT
A ( T )=
2a ( ) ( )(
2
−b T + 3 −
a a
e −1 ) + 3 ( e
4a
−2+ 1 )
Formula in L&S p. 795 with market price of risk factor.
σ2 c 2 σ2 c ( e−aT
A ( T )= ( 2a 2
−b−
a ) (
T+
2a 2
−b−
a ) a
( e−aT −1 ) σ 2 e−aT −1 σ 2
c
A ( T )= T − ( a )( 2a 2
−b−
a
+
a ) (
Infinitely long rate: σ2 λσ λσ c
Y ∞= b− 2+ ⇒ = ⇒
2a a a a
Formula for infinitely long rate with market price of risk from:
Craig Holden, Spreadsheet Modeling CD-ROM series, http://www.pr
Holden, Craig W. Holden. Spreadsheet Modeling in Investments, Pre
Vasicec Term Structure of Interest
9% Data Table
8% 0.852554
Vasicek Zero 0.001 0.99992
7% Rate 0.5 0.960797
6%
Long-term 1 0.923175
5% equilibrium
rate 2 0.852554
4% 3 0.787842
Infinitely long 4 0.728678
3% rate
5 0.674666
2% r at t=0 6 0.625399
1% 7 0.580475
8 0.539508
0%
9 0.502134
0 5Time to10maturity
15 20 25 30 35
10 0.468013
15 0.336216
20 0.249459
25 0.190067
30 0.147827
k Discount
This sheet has been added to compare the valuation of discount bonds
according the Vasicek (77) model both in the notation used by Longstaff &
Schwartz (95) and Hull in his well known derivatives textbooks (see
comment in cell A! for detailed reference)
with constants
z: long-term equilibrium of mean reverting process
b: "pull-back" factor - speed of adjustment
h: spot rate volatility
dZ2 standard Wiener process (N.B. Z1 is process for asset value)
Infinitely-long Rate (Y¥)
2
η
−
( 4β
3 ) ( e−2 βT −1 )
2
η
−
( 4β
3 ) ( e−2 βT −1 )
Floating Rate Debt. Journal of Finance. Vol 3. July 1995.

. 567.
of Financial Economics 5: 177-188.
η2
−βT
−1 ) −
( 4β
3 ) ( e−2 βT − 1 )
σ2
(e −aT
−1 ) −
( 4a 3 ) ( e−2 aT −1 )
−aT −2 aT
2 e +e )
4 a3
−aT −2 aT
e +e )
4 a3
σ 2 e−aT σ 2 e−2 aT
3
−
2a 4a3
2 −aT
e σ 2 e−2 aT
3
−
2a 4a3
e−2 aT −2+ 1 )
c ( e−aT −1 ) σ2
−b−
a ) a
−( 4 a3 )( e−2 aT −1 )
e−aT −1 σ 2 σ2
) +
a 2a2
− ( 4a 3
e−2 aT
)(
−1 ) )(
λσ c
⇒ = ⇒c= λσ
a a
market price of risk from:
g CD-ROM series, http://www.prenhall.com/holden/
eet Modeling in Investments, Prentice Hall (2002), p.49
Long-term equilibrium rate
8.000% 0 8.00%
7.998% 30 8.00%
7.994%
7.976% r at t=0
7.949% 0 8.00%
7.913%
7.871%
7.823% Infinitely long rate
7.770% 0 3.92%
7.714% 30 3.92%
7.654%
7.593%
7.267%
6.942%
6.642%
6.372%

Longstaff Schwartz (95) Risky Debt (P)

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Formulas in Longstaff & Schwartz 1995 for Risky Debt

Firm asset value process: with parameters

dV =μVdt+σ VdZ 1 V: firm asset value

dr= ( ζ−βr ) dt +ηdZ 2

Kurt Hess, kurthess@waikato.ac.nz 11/02/2021 25891234.xls Formulas

Values of floating-rate coupon payments (for T=t) 4%

Value risky discount bond

Structure of Interest Risky Discount Bonds

Credit Spread (in bps) 3%

Formulas in Longstaff & Schwartz 1995 for risky debt

P(X ,r,T )=D(r,T )−wD ( r,T ) Q ( X ,r,T )

0.1 0.045 0.0447755616

Risky (clean price)

Curve Risky vs. Riskless Coupon Bonds

Yield to Maturity Risky Bond

0 1 2Time to3 maturity

ing Rate Debt. Journal of Finance. Vol 3. July 1995.

X: ratio of V/K - firm asset value as % of bankruptcy threshold

List of iterations for q

Market Price of Interest Rate Risk l n.a. 0.0% 0 4%

Vasicec Discount Function

Formulas in Longstaff & Schwartz for Vasicek Model

Interest rate process: dr= ( ζ−βr ) dt +η dZ 2

L&S 95 Vasicek translated to Hull notation:

Floating Rate Debt. Journal of Finance. Vol 3. July 1995.

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