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Hedging Interest Rate Risk Using a Structural Model of Credit Risk

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  • Huang, Jing-Zhi

    (Pennslyvania State University)

  • Shi, Zhan

    (Ohio State University)

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.

Suggested Citation

  • Huang, Jing-Zhi & Shi, Zhan, 2016. "Hedging Interest Rate Risk Using a Structural Model of Credit Risk," Working Paper Series 2016-04, Ohio State University, Charles A. Dice Center for Research in Financial Economics.
    • Handle: RePEc:ecl:ohidic:2016-04
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    More about this item

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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