Just as we do with Credit Default Swaps, we can value defaultable bonds in terms of their non-defaultable 0-coupon bond prices and the risk neutral transition matrices Q(t).
Key questions leading to bond valuation
- WHERE is the bond’s current rating? $i, j, \cdots (k-1) $
- WHAT do you get if the bond
- survives: you get the PRICNCIPAL at time $T$
- defaults?
- WHEN do you get what you get?
- If at future time $T$ you discount to the present using a 0-coupon bond to obtain the net present value (NPV) if you do not default