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

92 Pages Posted: 25 Jun 2019 Last revised: 14 Feb 2023

See all articles by Santiago Forte

Santiago Forte

ESADE Business School, Ramon Llull University

Lidija Lovreta

EADA Business School

Date Written: April 2, 2019

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

Suggested Citation

Forte, Santiago and Lovreta, Lidija, Credit Default Swaps, the Leverage Effect, and Cross-Sectional Predictability of Equity and Firm Asset Volatility (April 2, 2019). Journal of Corporate Finance, 2023, Vol. 79, 102347., Available at SSRN: https://ssrn.com/abstract=3406756 or http://dx.doi.org/10.2139/ssrn.3406756

Santiago Forte (Contact Author)

ESADE Business School, Ramon Llull University ( email )

Av. Torreblanca 59
Sant Cugat del Vallès, Barcelona 08172
Spain

HOME PAGE: http://www.santiagoforte.com

Lidija Lovreta

EADA Business School ( email )

CIF ESG08902645
C/ Aragó 204
Barcelona, CP 08011
Spain

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