Alternate Hedge for Bonds Subject to Credit Risk

Abstract

To date there is no satisfactory way to measure and control interest rate risk for bonds subject to high levels of credit risk. In addressing this gap, this work develops the survival measure, a new measure of interest rate sensitivity for corporate bonds. An acid test of a sensitivity measure is its use as a hedge ratio. The hedge ratio based on a particular sensitivity measure that minimizes cash portfolio losses in response to an unexpected change in interest rates will be the "best" measure of interest rate risk. Accordingly, nine alternate hedge ratios, seven of which are new, are developed and examined. Considerable variations in the size of alternate hedge ratios suggest that improvements in hedging strategies may be available, depending on whether credit risky bonds have a consistently greater (less) response to a change in the level of interest than that suggested by the Macaulay duration based hedge ratio now used in practice. Some preliminary evidence suggests that the survival interest rate sensitivity measure developed here can improve hedging performance and therefore is a better measure of interest rate sensitivity for corporate bonds than Macaulay duration.

JEL Classification: G13