A two-factor hazard rate model for pricing risky debt and the term structure of credit spreads

This paper proposes a two-factor hazard rate model, in closed form, to pric e risky debt. The likelihood of default is captured by the firm's non-inter est sensitive assets and default-free interest rates. The distinguishing fe atures of the model are threefold. First, the impact of capital structure c hanges on credit spreads can be analyzed. Second, the model allows stochast ic interest rates to impact current asset values as well as their evolution . Finally, the proposed model is in closed form, enabling us to undertake c omparative statics analysis, compute parameter deltas of the model, calibra te empirical credit spreads, and determine hedge positions. Credit spreads generated by our model are consistent with empirical observations.