CDS Spreads Explained with Credit Spread Volatility and Jump Risk of Individual Firms
61 Pages Posted: 26 Aug 2012
Date Written: August 26, 2012
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: Suggested Citation