Interest rate dynamics of firm in financial distress (Vasicek model)

[Unusualskill]

Topic: Credit Risk and Credit Derivatives
May I ask why when interest rate volatility is high, the debt values are less sensitive to changes in interest rates?

Thank you!

 

[Unusualskill]

@David Harper CFA FRM can help me with this? Thank you!

 

[emilioalzamora1]

Hi @Unusualskill,

beyond the theory (which has been discussed by David in-depth in his learning resources; for example: https://forum.bionicturtle.com/threads/interest-rates-stultz.10689/)

In general I would say that it is very difficult to justify that high interest rate vol has less impact on debt values.


I can only share some hands-on practical (and very informative) industry insights:

https://www.coutts.com/insight-articles/news/2017/stronger-banks-and-the-bonds-opportunity.html

Here is a good overview about interest rate risk (sensitivity) to different classes of bonds:

https://www.thebalance.com/credit-risk-vs-interest-rate-risk-417059

 

[David Harper CFA FRM]

I completely agree with @emilioalzamora1 on this! That formatting looks like Kaplan, and indeed they have faithfully represented the assertions in Stulz Chapter 18.1 (is the source here). But this Stulz chapter is over 16 years old. Over the years, many of its assertions have proven problematic, at least in our forum discussions. Stulz 18.1 mixes theoretical model findings with empirical assertions, but empirical observations can of course vary over time, so it's not obvious some of them would be true today.

The specific point about interest rate volatility is esoteric and based on both a Vasicek assumption about the interest rate evolution and the cited Shimko variation of Merton-based model to price the debt (a variation that accepts a correlation parameter; e.g., Stulz uses -0.20, but that's subjective .... I'm not sure what happens if you change the correlation parameter). Like Emilio I cannot either defend unconditionally Stulz assertion that "when interest rate volatility is high, the debt values are less sensitive to changes in interest rates." It really depends ...

So I would be hesitant to rely greatly on some of this very dated material. Stulz is notoriously hard to read (to put it nicely) and he's fine for basic application of Merton, but most of the chapter (e.g., credit risk models) is outdated. I agree that you are better off with more current references. Thanks,