| This study presents a model for estimating the default risks implicit in the prices of callable corporate bonds.; The model considers three essential ingredients in the pricing of callable corporate bonds: interest rate uncertainty, default risk, and call feature. The interest rate uncertainty is modeled as a square-root diffusion process. The default risk is modeled as a constant spread, with the magnitude of this spread impacting the probability of a Poisson process governing the arrival of the default event. The call feature is modeled as a constraint on the value of the bond in the finite difference scheme.; The empirical results are encouraging in a number of respects. First, the historical pattern of estimated default probabilities is in line with Moody's findings. Estimated default probabilities for both investment-grade and speculative-grade bonds have been surging since 2000. Second, estimated default probabilities are consistent with Moody's ratings. Estimated default probabilities rise with lower ratings and fall with higher ratings. Third, the relationship between estimated default probabilities and a set of bond characteristics is intuitive. Estimated default probabilities are negatively correlated with maturity and positively correlated with coupon payment, age, and issue size. |
