Credit Default Swaps, the Leverage Effect, and Cross-Sectional Predictability of Equity and Firm Asset Volatility

Abstract

Leverage represents both a fundamental component of equity volatility and a long-run selection variable. Based on this premise, we investigate the influence of leverage on the long-run cross-sectional predictability of future realized equity volatility. Leverage makes equity volatility significantly less predictable than underlying firm asset volatility, a result that is robust to different predictors of future realized volatility: credit default swap implied, historical, and option implied volatility. A simple model of optimal capital structure, wherein companies maximize tax benefits subject to a common maximum default probability (minimum credit rating) target, helps explain this finding.

Keywords: Credit Default Swaps; Capital Structure; Asset Volatility; Equity Volatility; Leverage Effect; Cross-Sectional Predictability

JEL Classification: G12; G13; G14; G17; G32; G33