Firm-Specific Risk-Neutral Distributions : The Role of CDS Spreads

Aramonte, Sirio; Jahan-Parvar, Mohammad; Rosen, Samuel; Schindler, John W.

doi:10.17016/IFDP.2017.1212

Working Paper

Firm-Specific Risk-Neutral Distributions : The Role of CDS Spreads

Abstract: We propose a method to extract individual firms' risk-neutral return distributions by combining options and credit default swaps (CDS). Options provide information about the central part of the distribution, and CDS anchor the left tail. Jointly, options and CDS span the intermediate part of the distribution, which is driven by moderate-sized jump risk. We study the returns on a trading strategy that buys (sells) stocks exposed to positive (negative) moderate-sized jump risk unspanned by options or CDS individually. Controlling for many known factors, this strategy earns a 0.5% premium per month, highlighting the economic value of combining options and CDS.

Keywords: Risk neutral distributions; CDS spreads; Cross-section of expected returns;

JEL Classification: G12; G13; G14;

https://doi.org/10.17016/IFDP.2017.1212