Estimating Debt Betas∗

October 3, 2014

There are two approaches to estimating debt betas, both of which rely on the hedge
ratio of corporate debt with respect to the equity of the same firm. Define the hedge
ratio hE as:
% Change in debt value ∂D E
hE = = .
% Change in equity value ∂E D
Hence, the hedge ratio is the percentage in debt value relative to a percentage change
in equity value. These hedge ratios can be estimated and they provide a link between
equity betas βE and debt betas βD as follows:

βD = hE × βE .

The hedge ratio can be estimated in two different ways (see Schaefer and Strebulaev
2008 for details).

Method 1. Run a regression of the returns of a firm’s bond returns against the firm’s
equity returns. Here an additional complication arises, because the value of debt also
changes with changes in the risk-free rate. Hence, we need to control for changes in the
risk-free rate and run the following regression:

D E
rj,t = αj,0 + hj,E rj,t + αj,F rtF + uj,t .

D
Here, rj,t is the return on firmj 0 s bonds in period t, rj,t
E
is the return on firm j 0 s equity in
period t, and rtF is the return on a risk-free government bond. Schaefer and Strebulaev
use the 10-year treasury bond as a risk-free asset and also use excess returns instead of
∗
Ernst Maug, University of Mannheim, Area Finance, 68131 Mannheim, Germany. Email:
maug@corporate-finance-mannheim.de.

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raw returns, defined as the difference between bond returns, respectively stock returns,
and the risk-free rate. These regressions lead to the following results (see their Table
4), where estimates are provided for each rating class:

Empirical hedge ratios AAA AA A BBB BB B

hE × 100 0.61 1.17 3.16 4.00 8.27 15.22

Method 2. The second method uses a theoretical model of the firm to simulate the
connection between equity and debt. They use the model of Merton (1974). The
advantage of the model is that it can be calibrated to the parameters of the firm. For
their baseline calibration they obtain (see Panel B of their Table 8):

Theoretical hedge ratios AAA AA A BBB BB B

hE × 100 0.56 1.17 2.14 2.58 5.08 11.52

Consider two examples to apply this method:

Example 1. Consider a firm with AA-rated debt and an equity beta of 1.2. Estimate
the debt beta based on the empirical hedge ratio for AA-rated bonds, which is 1.17/100.
Then we have:
βD = 0.0117 × 1.2 = 0.014.

Example 2. Consider a firm with B-rated debt and an equity beta of 1.5, and estimate
the debt beta using the theoretical hedge ratio based on the Merton model:

βD = 0.1152 × 1.5 = 0.173.

Hence, it is safe to assume that for investment grade bonds (BBB or better), the
debt beta is zero, without generating noteworthy approximation errors when estimating
the cost of capital.

References
[1] Merton, Robert C., 1974, On the Pricing of Corporate Debt: The Risk Structure of
Interest Rates, Journal of Finance 29:2, 449-470.

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[2] Schaefer, Stephen M., and Ilya A. Strebulaev, 2008, Struc-
tural models of credit risk are useful: Evidence from hedge ra-
tios on corporate bonds, Journal of Financial Economics 90:1, 1-19
http://www.sciencedirect.com/science/article/pii/S0304405X08001001