Stress-testing Model of Defaultable Bond Values Banking Policy Department

This paper develops a stress-testing model to value defaultable bonds under stressful market conditions. Default occurs when some signaling process hits a pre-defined default barrier. The signaling variable is considered to be some macro-economic variables such as foreign exchange rates. The dynamics of the default barrier depends on the volatility and the drift of the signaling variable. We derive a closed-form solution of the defaultable bond price from the model as a function of a signaling variable and a short-term interest rate. The numerical results show that the model values generated by using foreign exchange rates as the signaling variables can broadly track the market credit spreads of defaultable bonds in emerging markets such as South Korea and Brazil. Given an expected level of the foreign exchange rate, defaultable bond values under stressful market conditions can be obtained. Thus, macro-economic factors can be incorporated into a stress-testing scenario of a defaultable bond portfolio to assess an institution’s capital position.