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riskneutralprob
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Joined: December 16th, 2005, 5:16 pm

Risky Corporate Bond Settlement Scenario

November 22nd, 2017, 7:47 pm

The settlement days convention for US Corporate Bonds is T+3.    So there are 2 dates:
   t_value
   t_settle  ( This is 3 business days after t_value )

Let's say you buy a corporate bond on t_value and the company defaults on day T+2,  what happens in general?  Same as normal?

Also, what about things like accrued interest?   Pay the full AI amount from (CpnStartAccrualDate, T+3)?

Thanks
 
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bearish
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Joined: February 3rd, 2011, 2:19 pm

Re: Risky Corporate Bond Settlement Scenario

November 26th, 2017, 11:28 pm

The terms of trade for any security that I can think of, certainly including US stocks and bonds, are pretty clear: you agree to exchange a certain amount of currency for a specific quantity of the security on the settlement date. Whatever happens to the value of the security between the trade date and the settlement date is the risk of the buyer. Caveat emptor.
 
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riskneutralprob
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Joined: December 16th, 2005, 5:16 pm

Re: Risky Corporate Bond Settlement Scenario

November 27th, 2017, 3:59 pm

So I include the possibility of the event occurring between trade and settle?  When adjusting the dirty price to settle price for a risky corporate bond, should I simply use risk free discounting?   If I adjust the survivals, I am conditioning on the event not occurring before settle date.   So, my question is, is the dirty price settlement adjustment simply:

DirtySettlePx(T+3) = DirtyPx(TradeDate) * ( 1 / df(T, T+3) )

My second question is about accrued interest.  Since the terms are set on trade date as you say, then is accrued interest assumed to be deterministic (ie not adjusted by survival probability) ?
 
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bearish
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Joined: February 3rd, 2011, 2:19 pm

Re: Risky Corporate Bond Settlement Scenario

November 28th, 2017, 2:16 am

I think you are overthinking this. The price agreed upon is the quantity on the left hand side of your equation. You are of course free to calculate the first term on the right by solving that equation, but I am not quite sure what you gain from that. Accrued interest is a very trivial mechanical calculation that counts days since the last coupon dates according to the relevant convention. There is no "modeling" going on there. The best way to think about it is that the quoted price, mechanically adjusted for AI, is what you will pay on the settlement date. That honest (aka dirty) short dated forward price should be the starting point for further analysis.
 
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Martinghoul
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Joined: July 18th, 2006, 5:49 am

Re: Risky Corporate Bond Settlement Scenario

November 28th, 2017, 9:44 am

I think your question has to do with a subject that's occasionally been discussed here...  Specifically, if and how to discount bonds for valuation purposes.
 
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DavidJN
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Joined: July 14th, 2002, 3:00 am

Re: Risky Corporate Bond Settlement Scenario

November 28th, 2017, 2:29 pm

From a legal perspective, when a bond defaults all accrued and future interest payment obligations disappear and the principal payment becomes due immediately. The market price of a bond then becomes the risk-adjusted PV of the recovery of principal, implying a recovery rate. 

Unless the default is a big surprise the market price wouldn't change that much between time t and t+2. Nonetheless, the buyer is obliged to pay on t+3 the price negoitiated at time t.