For credit analysis of a risky bond in a volatile interest rate environment, we use the arbitrage-free framework.
The first step in the arbitrage-free framework is to build the binomial interest rate tree under assumption of no arbitrage. Once the tree is built we need to verify that it is correctly calibrated.
Analyzing a fixed-coupon corporate bond:
This tree can then be used to analyze a fixed-coupon corporate bond. The steps are:
Analyzing a floater:
We can also use the arbitrage-free framework to analyze a floater. The process is similar to the analyzing a fixed coupon security. The steps are:
Impact of change in interest rate volatility: A change in the assumed level of interest rate volatility has a small impact on the fair value of a corporate bond.
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