Abstract
A firm‐value model similar to the one proposed by Black and Cox (1976) is considered. Instead of assuming a constant and known default boundary, the default boundary is an unobserved stochastic process. This process has a Brownian component, reflecting the influence of uncertain effects on the precise timing of the default, and a jump component, which relates to abrupt changes in the policy of the company, exogenous events or changes in the debt structure. Interestingly, this setup admits a default intensity, so the reduced form methodology can be applied. Part of this work was done while the first author stayed at the Isaac Newton Institute in Cambridge. Financial support from Isaac Newton Institute and Deutsche Forschungsgemeinschaft is gratefully acknowledged. The authors would like to thank M. Davis, L.C.G. Rogers, K. Giesecke and T. Bjrk for their inspiring comments and Ling Xu for her excellent help with the simulations. Moreover, the authors are grateful to N. Kordzakhia and two anonymous referees for their suggestions which helped to improve the paper considerably.
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