Credit default swap spreads and variance risk premia
Abstract: We find that firm-level variance risk premium, estimated as the difference between option-implied and expected variances, has a prominent explanatory power for credit spreads in the presence of market- and firm-level risk control variables identified in the existing literature. Such a predictability complements that of the leading state variable--leverage ratio--and strengthens significantly with lower firm credit rating, longer credit contract maturity, and model-free implied variance. We provide further evidence that: (1) variance risk premium has a cleaner systematic component and Granger-causes implied and expected variances, (2) the cross-section of firms' variance risk premia seem to price the market variance risk correctly, and (3) a structural model with stochastic volatility can reproduce the predictability pattern of variance risk premia for credit spreads.
File(s): File format is text/html http://www.federalreserve.gov/pubs/feds/2011/201102/201102abs.html
File(s): File format is application/pdf http://www.federalreserve.gov/pubs/feds/2011/201102/201102pap.pdf
Part of Series: Finance and Economics Discussion Series
Publication Date: 2011