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J. Risk Financial Manag. 2016, 9(2), 3; doi:10.3390/jrfm9020003

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

1
Saunders College of Business, Rochester Institute of Technology, Rochester, NY 14623, USA
2
Federal Reserve Bank of Atlanta, Atlanta, GA 30309, USA
*
Author to whom correspondence should be addressed.
Academic Editor: Jingzhi Huang
Received: 19 January 2016 / Revised: 28 March 2016 / Accepted: 27 April 2016 / Published: 10 May 2016
(This article belongs to the Special Issue Credit Risk)
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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. View Full-Text
Keywords: credit risk; structural models; credit default swap credit risk; structural models; credit default swap
This is an open access article distributed under the Creative Commons Attribution License which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited. (CC BY 4.0).

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MDPI and ACS Style

Huang, Z.J.; Luo, Y. Revisiting Structural Modeling of Credit Risk—Evidence from the Credit Default Swap (CDS) Market. J. Risk Financial Manag. 2016, 9, 3.

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