This paper proposes a two-factor hazard rate model, in closed form, to price risky debt. The distinguishing features of the model are threefold. First, the impact of capital structure changes on credit spreads can be analyzed. Second, the model allows stochastic interest rates to impact current asset values as well as their evolution. Finally, the proposed model is in closed form, enabling us to undertake comparative statics analysis, compute parameter deltas of the model, calibrate empirical credit spreads, and determine hedge positions.
Credit spreads generated by our model are consistent with empirical observations.