We develop a general structural model for valuing risky corporate debts that takes into account both default and interest rate risk. We propose a two-dimensional model in which the state variables are the value of the firm's assets and the short-term interest rate. The former follows a lognormal process and the latter a mean-reverting Gaussian process. Our methodology is based on dynamic programming and finite elements. We use parallel computing to enhance its efficiency. Our model accommodates flexible debt structure, multiple seniority classes, tax benefits, and bankruptcy costs. The results we obtain are consistent with empirical evidence documented in the literature.
Published December 2016 , 16 pages