Uncovering Market Discrepancies in the Corporate Bond Market using Estimated Asset Volatility Theory and Trading Simulation

Abstract

In this master thesis we empirically tests Merton’s (1974) structural model for valuing the corporate bonds of Ericsson and ABB. We argue that market inefficiencies are demonstrated by overreactions in asset volatility and Merton’s model is applied to identify these discrepancies. When testing Merton’s model, five different trading strategies are developed. The strategy with the highest risk adjusted return is the hedge fund approach. This proves that the model can provide useful information, since the hedge strategy is more sensitive to changes in asset volatility than any other strategy. The asset volatility discrepancies are uncovered and can be used to increase trading profits.