CDS Spreads Explained with Credit Spread Volatility and Jump Risk of Individual Firms

61 Pages Posted: 26 Aug 2012

See all articles by Arben Kita

Arben Kita

University of Southampton

Date Written: August 26, 2012

Abstract

This paper attempts to explain the credit default swap (CDS) premium by using a novel approach to identify the volatility and jump risks of individual firms from a unique dataset of high-frequency CDS spreads. I find that the volatility risk alone predicts 55% of the variation in CDS spread levels, while the jump risk alone explains 47%. After controlling for credit ratings, macroeconomic conditions and firms balance sheet information the model explains 93% of total variation. In the cross-section I find that volatility risk can explain 63% of the variation in the credit spreads whilst jump risk forecasts 55%. For the CDX index I find that the volatility risk alone predicts 22% of the variation in the CDX index levels, while the jump risk alone forecasts 25%. Overall, the results reported in this paper suggest that the time-varying volatility risk premium and jump risk premium of the credit spreads may play more important role than previously attributed to them.

Keywords: Credit Default Swap Spread, Credit Spread Volatility, Credit Spread Jump

JEL Classification: G12, G13

Suggested Citation

Kita, Arben, CDS Spreads Explained with Credit Spread Volatility and Jump Risk of Individual Firms (August 26, 2012). Available at SSRN: https://ssrn.com/abstract=2136458 or http://dx.doi.org/10.2139/ssrn.2136458

Arben Kita (Contact Author)

University of Southampton ( email )

Highfield Campus
Building 2
Southampton, Hampshire SO17 1BJ
United Kingdom

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