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Quantitative Finance by Matt Davison

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Chapter 7

Bond Pricing with Default

Using Difference Equations

7.1 CHAPTER SUMMARY

In Chapter 5, we presented a mathematical analysis of loans in which the borrower is certain to make the promised payments. In Chapter 6, we worked through an experimental simulation of risky loans for which there is a chance that, after some time, the borrower is unable to make all the proposed payments. How much more interest should the lender charge to make up for this chance? Using the similar mathematical difference equation formulism to that developed for our simple loan repayment problem, we address this question in this chapter. In so doing we develop a simple version of the so-called “reduced form model” of credit risk.

7.2 Risky Bonds

In Chapter 5, we ...

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