Performance and determinants of the Merton structural model: Evidence from hedging coefficients |
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| Institution: | 1. Risk Methodologies, Group Financial Risk, Group Risk Management, UniCredit S.p.A., Piazza Gae Aulenti, Tower A, Floor 20, 20154 Milan, Italy;2. ESADE Business School, Ramon Llull University, Av. Pedralbes 60-62, E-08034 Barcelona, Spain;1. Toulouse School of Economics, France;2. Copenhagen Business School, Department of Finance, Denmark;3. Strategic Research Department, SSE InfoNet Co. Ltd., Shanghai Stock Exchange, China;1. Department of Economics, University of Haifa, Haifa 31905, Israel;2. Research Department, Federal Reserve Bank Boston, 600 Atlantic Avenue, Boston, MA 02210, USA |
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| Abstract: | We empirically test the effectiveness of the Merton (1974) model in measuring the sensitivity of corporate bond returns to changes in equity value. We study the main variables that affect the performance of the model and relax the assumption of normally distributed rates of return. Results show that less than 6% of the bonds have a hedge ratio within 10% from the model predicted value. Volatility, time to maturity, size, distress, liquidity and information quality are found to be significant determinants of the efficacy of the model. |
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| Keywords: | Credit risk Hedge ratios Corporate bond spreads Spread sensitivity Distress Variance Gamma Normal Inverse Gaussian |
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