Exploring Credit Risk: Its Influence on Equity Strategies and Risk Management

Credit risk, also known as default risk, is the likelihood of loss when a borrower or counterparty fails to meet its obligations. A lot of research has been conducted on credit risk, and an emerging line of study explores the connection between the equity and credit markets. In this issue, we’ll discuss how credit risk impacts investment strategies in the equity market and how equity options can be used to hedge credit risk.

In this issue:

• Latest Posts

• Understanding Credit Risk and Its Impact on Invest …

  • Findings

• Using Equity Options to Hedge Credit Risks

  • Findings

• Closing Thoughts

• Educational Video

  • Merton KMV model for credit risks

• Volatility Weekly Recap

• Around the Quantosphere

Latest Posts

• Hedging Efficiently: How Optimization Improves Tail Risk Protection (8 min)

• Momentum Strategies: Profitability, Predictability, and Risk Management (8 min)

• The Predictive Power of Dividend Yield in Equity Markets (7 min)

• Monte Carlo Simulations: Pricing Weather Derivatives and Convertible Bonds (8 min)

• PCA in Action: From Commodity Derivatives to Dispersion Trading (8 min)

Understanding Credit Risk and Its Impact on Investment Strategies

Credit risk, also known as default risk, is the likelihood of loss from a borrower or counterparty not meeting its obligations. The Merton model, developed by Robert Merton, is a widely used model to measure a company's credit risk. Reference [1] examined how credit risk impacts momentum and contrarian strategies in the equity markets.

Findings

• Credit risk is measured using default risk, specifically the distance to default (DD) from the Kealhofer, McQuown, and Vasicek (KMV) model.

• High credit risk firms, when subjected to momentum and contrarian strategies, can generate excess returns.

• Medium credit risk firms also offer opportunities for excessive returns with these strategies.

• Low credit risk firms do not show significant relationships with momentum and contrarian returns.

• Investors should consider credit risk when implementing momentum and contrarian investment strategies.

• The applicability of these findings to the US and other developed markets is suggested for further research.

Reference

[1] Ahmed Imran Hunjra, Tahar Tayachi, Rashid Mehmood, Sidra Malik and Zoya Malik, Impact of Credit Risk on Momentum and Contrarian Strategies: Evidence from South Asian Markets, Risks 2020, 8(2), 37

Using Equity Options to Hedge Credit Risks

Using credit derivatives, such as credit default swaps, to manage credit risks is a common practice in the financial industry. Reference [2] proposed an approach that uses equity derivatives to partially hedge credit risks.

The author generalized the Merton structural model, where a company’s equity is viewed as a call option on its assets. However, instead of using the total debt level as the default trigger, the author proposed an alternative default threshold where default is determined by the stock price’s initial crossing of a predefined level. The credit loss then resembles the payoff of a digital put option.

Findings

• Building on Merton’s model, the paper defines default as the event where the stock price S_T falls below a set barrier, B.

• By establishing a link between this default model and the probability P(S_T < B) at time T, the study shows that hedging with a European put option can reduce the capital required for projected losses.

• An optimization problem is formulated to find the optimal strike price for the put option, minimizing risk based on a specific measure.

• Numerical analysis indicates that this method reduces the Solvency Capital Requirement (SCR) in both jump and non-jump markets, providing insurance companies with an effective way to reduce losses within their existing risk management structures.

Reference

 [2] Constantin Siggelkow, Partial hedging in credit markets with structured derivatives: a quantitative approach using put options, Journal of Derivatives and Quantitative Studies, 2024

Closing Thoughts

Credit risk remains a critical component shaping financial markets, with significant implications for equity investments. The growing research linking credit and equity markets highlights the importance of integrating credit risk considerations into investment strategies. Utilizing equity options for hedging provides a valuable approach to managing these risks effectively. As research in this area evolves, leveraging credit risk insights can enhance portfolio resilience and improve risk-adjusted returns.

Educational Video

Merton KMV model for credit risks

This video series provides an introduction to the Merton structural credit risk model. The Black-Scholes-Merton framework has significantly influenced credit risk measurement. The KMV-Merton model, widely used in credit markets, applies option theory to assess default risk. Merton (1974) noted that a firm's equity functions as a call option on its assets, with the strike price equal to its debt. Kealhofer, McQuown, and Vasicek (KMV) expanded on this concept, developing a commercial application that became so effective that Moody’s acquired KMV in 2002.

View the entire playlist (7 videos):

https://www.youtube.com/playlist?list=PLtlRowSvuTZQn78x205RcpDD7Rey7i0WW

Volatility Weekly Recap

The figure below shows the term structures for the VIX futures (in colour) and the spot VIX (in grey).

Stocks ended the week higher, though the S&P 500 missed a new record on Friday. Markets were driven by tariff news, earnings, and inflation data, with the S&P 500 up 1.49%, Nasdaq gaining 2.6%, and the Dow rising 0.5%. Mid-term VIX futures stayed flat, while short-term VIX futures moved into deeper contango. This resulted in returns of -4.46% and -0.54% for VXX and VIXM respectively.

Around the Quantosphere

• Credit Quants Target Bulk Trades to Conquer $8 Trillion Market (bnnbloomberg)

• The Secretive Hedge Fund Rewriting the Rules of $4.5 Trillion Industry (bloomberg)

• Study reveals hedge funds/fund managers are increasingly using alternative data for research and insights (opalesque)

• Investors switch from private equity to hedge funds, says BNP Paribas report (reuters)

• Hedge funds charging billions in ‘no limit’ pass-through fees (hedgeweek)

Disclaimer

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