Pricing of defaultable securities under stochastic interest

Abstract

We reduce a problem of pricing continuously monitored defaultable securities (barrier options, corporate debts) in a stochastic interest rate framework to calculations of boundary crossing probabilities (BCP) for Brownian Motion (BM) with stochastic boundaries. In the case when the interest rate is governed by a linear stochastic equation (Vasicek model) we suggest a numerical algorithm for calculation of BCP based on a piece-wise linear approximation for the stochastic boundaries. We also find an estimation of the rate of convergence of the suggested approximation and illustrate results by numerical examples. © 2008 Springer-Verlag Berlin Heidelberg.