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

by Stephen M. Schaefer of the London Business School, and
Ilya A. Strebulaev of the London Business School

May 2004

Abstract: It is well known that structural models of credit risk provide poor predictions of bond prices. We show that, despite this, they provide quite accurate predictions of the sensitivity of corporate bond returns to changes in the value of the equity of the issuing firm. This is important since it allows us 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 not rejected in either time series or cross-sectional test. 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 strongly related to VIX, an index of implied volatility on equity index futures, and the Fama-French SMB factor in way that is not predicted by structural models.

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

Published in: Journal of Financial Economics, Vol. 90, No. 1, (October 2008), pp. 1-19.

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