Contingent Claims and Hedging of Credit Risk with Equity Options

Abstract

We introduce a novel methodology to hedge changes in the market values of credit exposures using equity put options. Our new hedge ratios are derived from the application of contingent-claims valuation and are fundamentally different from existing hedging methods aimed at neutralizing the loss following the occurrence of a credit event. We provide evidence that the theoretical hedge ratios are in line with the empirical sensitivities of credit spread changes to put option returns and that, relative to the latter, reduce volatility by a further 15% in an out-of-sample setting including a portfolio of North American firms. Based on in-sample estimates, hedging with options reduces portfolio volatility by an additional 13% relative to hedging with equity. We show that option hedge ratios capture option-specific credit exposure related to the VIX index and the default spread, which is unaccounted for by Merton (1974)'s equity hedge ratios alone. These findings shed new light on the puzzling weak relation between equity and credit returns reported in previous studies and suggest that the predictions of Merton's structural model can be enhanced by combining equity-specific with option-specific information.