In one way or another, business activity must be financed. Without finance to support
their fixed assets and working capital requirements, businesses could not exist. There are
three primary sources of finance for companies:
● a cash surplus from operating activities
● new equity funding
● borrowing from bank and non-bank sources. Non-bank sources are mainly investors in
the capital markets who subscribe for bonds and other securities issued by companies.
A non–financial variable not specific to a party to the contract includes, for example,
an index of earthquake losses in a particular region and an index of temperatures in
a particular city. A non–financial variable specific to a party would be, for example,
the occurrence or non-occurrence of a fire that damages or destroys an asset of a
party to the contract.
The pricing of credit-sensitive bonds, that is, bonds which have a significant probability of
default, is an issue of increasing academic and practical importance. The recent practice in
financial markets has been to issue high yield corporate bonds that are a hybrid of equity and
risk-free debt. Also, to an extent, most corporate bonds are credit-sensitive instruments,
simply because of the limited liability of the issuing enterprise. In this paper, we suggest and
implement a model for the pricing of options on credit-sensitive bonds.