Structural Models of Credit Risk are Useful: Evidence from Hedge Ratios on Corporate Bonds

Abstract:     
It is well known that structural models of credit risk provide poor predictions of bond prices. We show that they may perform much better as a predictor of debt return sensitivities to equity. This is important since it gives us an opportunity to identify much better the reasons for model failure. The main result of this paper is that even the simplest of the structural models (Merton (1974)) produces hedge ratios that are in line with those observed empirically. As well as providing insight into the determinants of corporate bond prices our results are also useful to practitioners who wish to hedge their positions in corporate debt. The paper also shows that corporate bond prices are sensitive to some variables - e.g., VIX - in a way that appears unrelated to credit risk.

Keywords: Credit risk, structural models, hedge ratios, credit spreads

JEL Classifications: G12, G32, G33

Working Paper Series