Credit Default Swap Spreads and Variance Risk Premia

Abstract:     
We find that variance risk premia, defined as the spread between the option-implied and expected variances, have a prominent predictability for the credit default swap spreads at individual firm level. Such a predictability cannot be crowded out by that of the market and firm level credit risk factors identified in previous research. We demonstrate that the strong predictability of implied variance for credit spreads is mostly explained by either variance premium or expected variance. Our findings suggest that variance risk premium is a relatively clean measure of a firm’s exposure to macroeconomic uncertainty or systematic variance risk, while option-implied variance may be contaminated by idiosyncratic variance risk. Such a result is consistent with the market level evidence that variance risk premium predicts credit spread variation.

Keywords: variance risk premia, credit default swap spreads, option-implied variance, expected variance, realized variance

JEL Classifications: G12, G13, G14

Working Paper Series