Abstract
This article presents a tractable structural model in which default may be both expected or unexpected. The model can predict realistically high short-term credit spreads. Closed form solutions are provided for corporate bonds and default swaps. The analysis suggests that, in order for the observed short-term yield spreads on high grade corporate debt to be compensation for credit risk, the market must believe that unexpected default may occur at any time, even if it is extremely unlikely, and that it may cause a dramatic sudden ‘downfall’ in the firm's assets value.