Option-Based Credit Spreads

44 Pages Posted: 17 Dec 2014 Last revised: 12 Sep 2017

See all articles by Christopher L. Culp

Christopher L. Culp

Johns Hopkins University - Institute for Applied Economics, Global Health, and Study of Business Enterprise; Swiss Finance Institute; Compass Lexecon; Financial Economics Consulting, Inc.

Yoshio Nozawa

Hong Kong University of Science and Technology

Pietro Veronesi

University of Chicago - Booth School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Multiple version iconThere are 3 versions of this paper

Date Written: September 2, 2017

Abstract

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

Culp, Christopher L. and Nozawa, Yoshio and Veronesi, Pietro, Option-Based Credit Spreads (September 2, 2017). Chicago Booth Research Paper No. 15-49; Fama-Miller Working Paper. Available at SSRN: https://ssrn.com/abstract=2538876 or http://dx.doi.org/10.2139/ssrn.2538876

Christopher L. Culp

Johns Hopkins University - Institute for Applied Economics, Global Health, and Study of Business Enterprise ( email )

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Swiss Finance Institute ( email )

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Yoshio Nozawa

Hong Kong University of Science and Technology ( email )

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Hong Kong

Pietro Veronesi (Contact Author)

University of Chicago - Booth School of Business ( email )

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773-702-6348 (Phone)
773-702-0458 (Fax)

Centre for Economic Policy Research (CEPR)

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United Kingdom

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
United States

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