Discussion Papers, Department of Finance and Management Science, Norwegian School of Economics (NHH)
No 2008/6:
Level dependent annuities: Defaults of multiple degrees
Aksel Mjøs ()
and Svein-Arne Persson ()
Abstract: Motivated by the risk of stopped debt coupon payments from
a leveraged company in financial distress, we value a level dependent
annuity contract where the annuity rate depends on the value of an
underlying asset-process. The range of possible values of the asset is
divided into a finite number of regions. The annuity rate is constant
within each region, but may differ between the regions. We consider both in
finite and finite annuities, with or without bankruptcy risk, i.e.,
bankruptcy occurs if the asset value process hits an absorbing boundary.
Such annuities are common in models of debt with credit risk in financial
economics. Suspension of debt service under the US Chapter 11 provisions is
one well-known real-world example. We present closed-form formulas for the
market value of such multi-level annuities contracts when the market value
of the underlying asset is assumed to follow a geometric Brownian
motion.
Keywords: Multi-level annuity; credit risk; financial distress; (follow links to similar papers)
JEL-Codes: G13; G32; G33; (follow links to similar papers)
24 pages, March 12, 2008
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