As a valuation model for the risky coupon bonds, the Kim, Ramaswamy and Sundaresan model can be applied to the valuation of the premiums of the performance guarantees such as advance payment bonds, performance bonds, etc. due to the close relationship between the credit spreads and the premiums of guarantees. This thesis surveys the Korean performance guarantees market in depth with pricing cases. For the methodology of implementing the model, Monte Carlo simulation of antithetic variate technique is used, in which default rates and recovery rates of the bond issuers are endogenously produced. Fifteen bond issuers are selected and spot rates of the bonds and government bonds are bootstrapped. The volatilities of the firm values are obtained by the iterative technique with Monte Carlo simulation and the parameters of the Cox-Ingersoll-Ross interest rate process by general method of moments. Credit spreads of the model and bond markets are finally computed and converted into the premiums of guarantees. The model shows less explanatory power for the market credit spreads. Duration, firm value volatilities and payout ratios are found out the major factors affecting spread errors. To fit the credit spreads better, payout ratios are varied as a pivotal measure, consequently giving plausible results for the premiums. The model premiums are higher than those of financial institutions in Korea, and the term structures show an upward trend in high credit-grade companies but up-and-down styles in lower credit-grade companies. But institutions’ premiums are step styles or a constant increasing style. The reasons are severe competition in the guarantees market, expectation for less callings, and experiences for the short-term periods of performance guarantees beside the intrinsic errors from the model, which are assumptions of the fixed capital structure of a firm in a perfect market, prohibiting effort to protect defaults. However, the results might be different according to payout ratios in long-term periods and firm value volatilities.
Further, the KMV method is applied to the model to anticipate a firm’s default. The model shows a very close relationship between the endogenous default rates, credit spread and volatility and deterioration of a firm’s viability. Further studies are left for the future research.
