Adjusting the Binomial Model for Default Risk

Abstract

Th arbitrage-free binomial model has been applied to value bonds with embedded options. This article extends the binomial model to incorporate the risk of payment default. The basic solution procedure is modified by adjusting the expected cash flows for the likelihood of a payment default and the expected cash recovery when a payment default occurs. The default probabilities can be estimated from the historical default experience of similarly rated bonds. The expected cash recoveries can be estimated by calibrating to the yield curve for par value bonds with the same rating. The author applies the model to value payment-in-kind debentures, which are rich in embedded options.