Please use this identifier to cite or link to this item: http://hdl.handle.net/10419/178583
Authors: 
Zeitsch, Peter J.
Year of Publication: 
2017
Citation: 
[Journal:] Journal of Risk and Financial Management [ISSN:] 1911-8074 [Volume:] 10 [Year:] 2017 [Issue:] 1 [Pages:] 1-23
Abstract: 
By reinterpreting the calibration of structural models, a reassessment of the importance of the input variables is undertaken. The analysis shows that volatility is the key parameter to any calibration exercise, by several orders of magnitude. To maximize the sensitivity to volatility, a simple formulation of Merton's model is proposed that employs deep out-of-the-money option implied volatilities. The methodology also eliminates the use of historic data to specify the default barrier, thereby leading to a full risk-neutral calibration. Subsequently, a new technique for identifying and hedging capital structure arbitrage opportunities is illustrated. The approach seeks to hedge the volatility risk, or vega, as opposed to the exposure from the underlying equity itself, or delta. The results question the efficacy of the common arbitrage strategy of only executing the delta hedge.
Subjects: 
Merton model
structural model
Credit Default Swap
capital structure arbitrage
algorithmic trading
JEL: 
G12
G13
Persistent Identifier of the first edition: 
Creative Commons License: 
https://creativecommons.org/licenses/by/4.0/
Document Type: 
Article
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