wilmott.com

Hi!In a credit ratings model, for example Jarrow, Lando, Turnbull(1997), it is assumed that we can hedge the different transition jumps with zero-coupon bonds. Now in my understanding, this means going short bonds(?).How can we find bonds to hedge with(are there (enough) corporate zero-coupon bonds)? Since I have very little practical experience, I would also like to know how "easy" it is to short corporate bonds. Is this as easy as shorting stock, or..?

Is shorting stock easy? I don't think it is, it's much harder than buying stock. You need a compliant broker for a start, margin, and you can still be caught in a short squeeze and closed out, and the US has these bizarre Communistic rules about only allowing shorting after an uptick (imagine if they only let you buy after a downtick!).If we consider being long a corporate bond as equivalent to being long a risk-free bond and having sold a put on the company's value, then shorting a corporate bond much be equivalent to shorting a risk-free bond and buying such a put. You could essentially achieve this via a credit default swap where you buy protection in the event of a default and pay fixed.

QuoteOriginally posted by: MattFIf we consider being long a corporate bond as equivalent to being long a risk-free bond and having sold a put on the company's value, then shorting a corporate bond much be equivalent to shorting a risk-free bond and buying such a put. You could essentially achieve this via a credit default swap where you buy protection in the event of a default and pay fixed.Yes, but this would be a put on the Firm Value (Equity plus Debt) while in the market you can only trade puts on the equity. Thus your replication will never be perfect. In particular, the "firm volatility" will be important for you to calculate your hedge ratio, but this value is not directly observable. And equity volatility is a weak proxy.You could look at a CreditGrades or KMV market calibrated model to estimate firm vol, but I'm not 100% confident in their methods.

QuoteOriginally posted by: HavrevoldSince I have very little practical experience, I would also like to know how "easy" it is to short corporate bonds. Is this as easy as shorting stock, or..?Shorting corporates is much more difficult than shorting stock. Stock loan is an old business that people are comfortable with. I think you could also make the point that the fact that equities are exchange traded makes both counterparties more comfortable with the idea of borrowing something, selling it, buying it back again, and then returning it.There's not so much history with shorting corporates, the market is newer. Not as much volume, etc.

You could also try synthesizing a corporate short by buying credit protection and going short on a treasury (= paying fixed on a swap). The CDS and treasury/swap market may be a more liquid way to put on (and unravel) this trade, however, it may not be exact if the CDS market doesn't reflect the credit spreads quite right.