Trading Profits from the Merton Credit Model

I wanted to give you advance notice of Kamakura credit risk research completed yesterday on the trading profits from the use of the Merton credit model.

The Merton model predicts that if the value of company asssets RISE equity prices rise and credit spreads fall and that if the value of company assets
FALL equity prices fall and credit spreads rise.

If one had one day advance notice of stock price movements, an arbitrage
strategy based on the Merton model would be to buy bonds of a company whose stock price was known in advance to rise and to sell bonds of a company whose stock price was known in advance to fall.

A naive strategy of flipping a coin would result in profits 50% of the time.

In an extensive historical study involving a wide range of corporate issuers suggested by major international banks, we show the following:

1. A trader who had one day advance notice of stock price movements and who took Merton model-based positions would HAVE LOST MONEY 56% OF THE TIME in a sample of 16,200 credit spreads on the bonds issued by Enron.

2. A trader who had one day advance notice of stock price movements would have, on average, lost money more often than a trader who flipped a coin to decide whether to go long or short on a particular corporate bond based on an extensive sample of major corporate issuers.

The preliminary summary of these research findings has been incorporated in a revised overview of Kamakura credit risk products and services. If you would like a copy, please let us know. We look forward to your comments on our research findings as we are preparing the results for publication later this year.

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