Hedging interest rate risk using a structural model of credit risk

This paper investigates predictions of structural credit risk models for interest rate sensitivities of corporate bond returns. Recent evidence has shown that the existing models fail to capture this sensitivity (a stylized fact referred to as the interest rate sensitivity puzzle). We propose and estimate a structural model that incorporates a three-factor dynamic term structure model (DTSM) into the Merton (1974) model. We show that the proposed model captures the sensitivity of corporate bond returns to the entire yield curve, thereby providing a solution to the puzzle. In addition, hedging effectiveness substantially improves under the proposed model. Our results indicate that to better capture and hedge the interest rate exposure of corporate bond returns, we need to incorporate a more realistic DTSM in the existing structural models. Lastly, we find that frictions in the corporate bond and equity markets as well as time-varying volatility constitute major impediments to further improvement in hedging effectiveness