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http://ssrn.com/abstract=676420
 
 

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Explaining the Level of Credit Spreads: Option-Implied Jump Risk Premia in a Firm Value Model


Martijn Cremers


University of Notre Dame

Joost Driessen


Tilburg University - Department of Finance; CentER Tilburg University

Pascal J. Maenhout


INSEAD - Finance

July 2006

BIS Working Paper No. 191
EFA 2006 Zurich Meetings

Abstract:     
Prices of equity index put options contain information on the price of systematic downward jump risk. We use a structural jump-diffusion firm value model to assess the level of credit spreads that is generated by option-implied jump risk premia. In our compound option pricing model, an equity index option is an option on a portfolio of call options on the underlying firm values. We calibrate the model parameters to historical information on default risk, the equity premium and equity return distribution, and S&P 500 index option prices. Our results show that a model without jumps fails to fit the equity return distribution and option prices, and generates a low out-of-sample prediction for credit spreads. Adding jumps and jump risk premia improves the fit of the model in terms of equity and option characteristics considerably and brings predicted credit spread levels much closer to observed levels.

Number of Pages in PDF File: 50

Keywords: Credit spreads, jump risk premium, firm value model

JEL Classification: G12, G13

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Date posted: March 4, 2005  

Suggested Citation

Cremers, Martijn and Driessen, Joost and Maenhout, Pascal J., Explaining the Level of Credit Spreads: Option-Implied Jump Risk Premia in a Firm Value Model (July 2006). BIS Working Paper No. 191; EFA 2006 Zurich Meetings. Available at SSRN: http://ssrn.com/abstract=676420 or http://dx.doi.org/10.2139/ssrn.676420

Contact Information

K. J. Martijn Cremers (Contact Author)
University of Notre Dame ( email )
P.O. Box 399
Notre Dame, IN 46556-0399
United States
Joost Driessen
Tilburg University - Department of Finance ( email )
P.O. Box 90153
Tilburg, 5000 LE
Netherlands
CentER Tilburg University ( email )
P.O. Box 90153
Tilburg, 5000 LE
Netherlands
Pascal J. Maenhout
INSEAD - Finance ( email )
Boulevard de Constance
F-77305 Fontainebleau Cedex
France
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