Option-Based Credit Spreads
44 Pages Posted: 17 Dec 2014 Last revised: 12 Sep 2017
Date Written: September 2, 2017
We present a novel empirical benchmark for analyzing credit risk using “pseudo firms” that purchase traded assets financed with equity and zero-coupon bonds. By no-arbitrage, pseudo bonds are equivalent to Treasuries minus put options on pseudo-firm assets. Empirically, like corporate spreads, pseudo-bond spreads are large, countercyclical, and predict lower economic growth. Using this framework, we find that bond market illiquidity, investors’ over-estimation of default risks, and corporate frictions do not seem to explain excessive observed credit spreads, but, instead, a risk premium for tail and idiosyncratic asset risks is the primary determinant of corporate spreads.
Keywords: credit spreads, credit risk, default, bonds, Merton model
JEL Classification: G12, G13, G21, G3
Suggested Citation: Suggested Citation