On the Valuation and Analysis of Risky Debt: A Practical Approach Using Rating Migrations

Abstract

This paper is concerned with the valuation and analysis of risky debt instruments with arbitrary interest and principal payments subject to default risk. For the valuation, we use a risk-neutral present value model with expected payments for risk-neutral investors and risk-free spot rates. The required risk-neutral default probabilities are derived from historically observable risk-averse migration matrices. Based on this debt valuation, we calculate various key figures for the analysis of risky debt from the point of view of risk-averse investors (e.g., promised and expected yields, yield spreads, Z-spreads, risk premia, risk-averse default probabilities, and risk-averse expected payments). Our approach is well-suited for practical applications, since the parameters required are easily available from observable data.