Revisiting Structural Modeling of Credit Risk—Evidence from the Credit Default Swap (CDS) Market

Zhijian (James) Huang and Yuchen Luo
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Zhijian (James) Huang: Saunders College of Business, Rochester Institute of Technology, Rochester, NY 14623, USA
Yuchen Luo: Federal Reserve Bank of Atlanta, Atlanta, GA 30309, USA

JRFM, 2016, vol. 9, issue 2, 1-20

Abstract: The ground-breaking Black-Scholes-Merton model has brought about a generation of derivative pricing models that have been successfully applied in the financial industry. It has been a long standing puzzle that the structural models of credit risk, as an application of the same modeling paradigm, do not perform well empirically. We argue that the ability to accurately compute and dynamically update hedge ratios to facilitate a capital structure arbitrage is a distinctive strength of the Black-Scholes-Merton’s modeling paradigm which could be utilized in credit risk models as well. Our evidence is economically significant: We improve the implementation of a simple structural model so that it is more suitable for our application and then devise a simple capital structure arbitrage strategy based on the model. We show that the trading strategy persistently produced substantial risk-adjusted profit.

Keywords: credit risk; structural models; credit default swap (search for similar items in EconPapers)
JEL-codes: C E F2 F3 G (search for similar items in EconPapers)
Date: 2016
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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