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.

Number of Pages in PDF File: 42

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

JEL Classification: G12, G13, G14

working papers series