Hedging Interest Rate Risk Using a Structural Model of Credit Risk

Jingzhi Huang and Zhan Shi
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Zhan Shi: Ohio State University

Working Paper Series from Ohio State University, Charles A. Dice Center for Research in Financial Economics

Abstract: Recent evidence has shown that structural models fail to capture interest rate sensitivities of corporate debt. We consider a structural model that incorporates a three-factor dynamic term structure model (DTSM) into the Merton (1974) model. We show that the proposed model largely captures the interest rate exposure of corporate bonds. We also find that for investment-grade bonds, hedging effectiveness substantially improves under the proposed model. Our results indicate that to better capture and hedge the interest rate exposure of corporate bonds, we need to incorporate a more realistic DTSM in the existing structural models.

JEL-codes: G12 G13 G24 G33 (search for similar items in EconPapers)
Date: 2016-02
New Economics Papers: this item is included in nep-cfn, nep-fmk and nep-rmg
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Persistent link: https://EconPapers.repec.org/RePEc:ecl:ohidic:2016-04

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