Credit Default Swap Spreads and Variance Risk Premia

42 Pages Posted: 11 Mar 2010 Last revised: 5 Sep 2010

See all articles by Hao Wang

Hao Wang

Tsinghua University

Hao Zhou

SUSTech Business School; Tsinghua University - PBC School of Finance

Yi Zhou

San Francisco State University

Multiple version iconThere are 3 versions of this paper

Date Written: August 31, 2010

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.

Keywords: Variance Risk Premia, Credit Default Swap Spreads, Option-Implied Variance, Expected Variance, Realized Variance

JEL Classification: G12, G13, G14

Suggested Citation

Wang, Hao and Zhou, Hao and Zhou, Yi, Credit Default Swap Spreads and Variance Risk Premia (August 31, 2010). AFA 2011 Denver Meetings Paper, Available at SSRN: https://ssrn.com/abstract=1568216 or http://dx.doi.org/10.2139/ssrn.1568216

Hao Wang

Tsinghua University ( email )

318 Weilun Building
Tsinghua University
Beijing, 100084
China
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Hao Zhou

SUSTech Business School ( email )

1088 Xueyuan Avenue, Nanshan District
Southern University of Science and Technology
Shenzhen, Guangdong
China
+86-0755-88010464 (Phone)

Tsinghua University - PBC School of Finance ( email )

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China
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Yi Zhou (Contact Author)

San Francisco State University ( email )

College of Business
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San Francisco, CA 94132
United States
(415) 338-2661 (Phone)
(415) 338-0596 (Fax)

HOME PAGE: http://cob.sfsu.edu/directory/yi-zhou

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