Contingent Claims and Hedging of Credit Risk with Equity Options

55 Pages Posted: 24 May 2018 Last revised: 6 Aug 2019

See all articles by Davide E. Avino

Davide E. Avino

University of Liverpool; Financial Mathematics and Computation Cluster

Enrique Salvador

Universitat Jaume I - Department of Finance and Accounting

Date Written: May 23, 2018

Abstract

We introduce a novel methodology to hedge changes in the market values of credit exposures using equity put options. Our new hedge ratios are derived from the application of contingent-claims valuation and are fundamentally different from existing hedging methods aimed at neutralizing the loss following the occurrence of a credit event. We provide evidence that the theoretical hedge ratios are in line with the empirical sensitivities of credit spread changes to put option returns and that, relative to the latter, reduce volatility by a further 15% in an out-of-sample setting including a portfolio of North American firms. Based on in-sample estimates, hedging with options reduces portfolio volatility by an additional 13% relative to hedging with equity. We show that option hedge ratios capture option-specific credit exposure related to the VIX index and the default spread, which is unaccounted for by Merton (1974)'s equity hedge ratios alone. These findings shed new light on the puzzling weak relation between equity and credit returns reported in previous studies and suggest that the predictions of Merton's structural model can be enhanced by combining equity-specific with option-specific information.

Keywords: Credit Risk, Contingent Claims, Hedging, CDS, Options

JEL Classification: E43, E44, G10

Suggested Citation

Avino, Davide E. and Salvador, Enrique, Contingent Claims and Hedging of Credit Risk with Equity Options (May 23, 2018). Available at SSRN: https://ssrn.com/abstract=3184004 or http://dx.doi.org/10.2139/ssrn.3184004

Davide E. Avino (Contact Author)

University of Liverpool ( email )

Chatham Street
Liverpool, L69 7ZA
United Kingdom

Financial Mathematics and Computation Cluster

Dublin
Ireland

Enrique Salvador

Universitat Jaume I - Department of Finance and Accounting ( email )

Castellon
E-12071 Castello de la Plana, Castellón de la Plana 12071
Spain

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