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

50 Pages Posted: 18 Jun 2004 Last revised: 23 Dec 2007

See all articles by Ilya A. Strebulaev

Ilya A. Strebulaev

Stanford University - Graduate School of Business; National Bureau of Economic Research

Stephen M. Schaefer

London Business School - Institute of Finance and Accounting

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 Classification: G12, G32, G33

Suggested Citation

Strebulaev, Ilya A. and Schaefer, Stephen M., Structural Models of Credit Risk are Useful: Evidence from Hedge Ratios on Corporate Bonds. AFA 2005 Philadelphia Meetings; EFA 2004 Maastrict Meetings Paper No. 4764. Available at SSRN: https://ssrn.com/abstract=556928 or http://dx.doi.org/10.2139/ssrn.556928

Ilya A. Strebulaev

Stanford University - Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States

HOME PAGE: http://faculty-gsb.stanford.edu/strebulaev/

National Bureau of Economic Research ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Stephen M. Schaefer (Contact Author)

London Business School - Institute of Finance and Accounting ( email )

Sussex Place
Regent's Park
London NW1 4SA
United Kingdom
+44 171 706 6887 (Phone)
+44 171 724 3317 (Fax)

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