Abstract
Structural models for pricing credit risk can be used to forecast the spread on risky bonds and for hedging credit risk. This article examines the forecasting accuracy of the Black–Scholes–Merton (BSM) model of risky debt using a data set consisting of weekly bond data for First Interstate Bancorp over the period January 1986–August 1993. In addition, structural model hedge parameters and credit spread options are tested for their effectiveness in hedging the increasing credit risk premium on First Interstate Bancorp debt. Credit spread options in combination with a duration hedge offer the best hedging strategy, reducing the standard deviation of the hedging error by a minimum of 84%.
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