ertaining the risk-neutral transition matrices is critical in this framework, where the payoff depends on the credit rating of a certain party. These transition matrices can be obtained from empirically observed or real world transition matrices, observed bond prices and observed interest rates.However, when it comes to the pricing of bonds with embedded prepayment options, the demarcation between credit rating upgradation as a trigger for the exercise of the option and interest rate decline as the trigger for the exercise of the option is not very clear. In this scenario, the best way to combine interest rate and credit risk is to use both, the risk neutral transition matrix, and the risk neutral interest rate tree.The valuation procedure involves backward recursion of the bond cash flows (including the embedded option) starting out with the terminal period, separately for each interest rate path. The price of the bond is the mean of the values arrived at in each path. It is noteworthy that the mean can be used only in a risk-neutral setting. The option value is the difference between the bond value (alongwith the embedded option) and the value of a plain bond....
