Newsletter: Exploring Credit Risk, Its Influence on Equity Strategies and Risk Management
How credit risk impacts investment strategies in the equity market and how to hedge credit risk
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.
Live webcast
I'll be doing a special live broadcast with David A. Janello, PhD, CFA at Nuclear Option Trading ,where we'll discuss how to apply academic research when developing trading strategies.
It’s on Wednesday Feb 19, 4.15 pm. ET, 3.15 pm CT
We’ll also discuss research papers on the seasonality of volatility and the overnight risk premium.
If you have any questions you'd like us to cover during the broadcast, feel free to leave them in the comments below.
Web-only posts Recap
Below is a summary of the web-only posts I published during last week.
How Salient Information Impacts Stock Momentum and Reversals
Breaking Down the Volatility Risk Premium: Overnight vs. Intraday Returns
How Investors Overreact During Bull and Bear Markets?
Using ChatGPT to Extract Market Sentiment for Commodity Trading
Beta Anomaly in the International Stock Markets
Retail Options Traders’ Behaviour
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, utilizing quantitative parameters. 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 ST falls below a set barrier, B.
- By establishing a link between this default model and the probability P(ST < 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
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)
Recent Newsletters
Below is a summary of the weekly newsletters I sent out recently
-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)
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