Credit Default Swap Spreads and Variance Risk Premia
PBC School of Finance, Tsinghua University
Florida State University, College of Business, Department of Finance
August 31, 2010
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, G14working papers series
Date posted: October 25, 2009 ; Last revised: June 12, 2011
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