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

Author

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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)

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.

Suggested Citation

  • Zhijian (James) Huang & Yuchen Luo, 2016. "Revisiting Structural Modeling of Credit Risk—Evidence from the Credit Default Swap (CDS) Market," JRFM, MDPI, vol. 9(2), pages 1-20, May.
    • Handle: RePEc:gam:jjrfmx:v:9:y:2016:i:2:p:3-:d:69765
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    References listed on IDEAS

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    Cited by:

    1. Peter J. Zeitsch, 2017. "Capital Structure Arbitrage under a Risk-Neutral Calibration," JRFM, MDPI, vol. 10(1), pages 1-23, January.

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