Firm-Specific Risk-Neutral Distributions: The Role of CDS Spreads
67 Pages Posted: 31 Jan 2017 Last revised: 20 May 2019
Date Written: October 30, 2018
We propose a method to extract the risk-neutral distribution of firm-specific stock returns by combining options and credit default swaps (CDS). Options provide information about the central part of the distribution, and CDS anchor the left tail. Jointly, but not in isolation, options and CDS span the intermediate part of the distribution, which is driven by exposure to the risk of large but not extreme returns. We study the returns on a trading strategy buying (selling) stocks that are more (less) exposed to such risk. Controlling for many known factors, this strategy earns a 0.5% premium per month. The results are robust to using CDS of different maturities.
Keywords: Risk neutral distributions, CDS spreads, Cross-section of expected returns
JEL Classification: G12, G13, G14
Suggested Citation: Suggested Citation