56 Pages Posted: 30 Jun 2004
Date Written: December 2004
This paper introduces measures of volatility and skewness that are based on individual stock options to explain credit spreads on corporate bonds. Implied volatilities of individual options are shown to contain important information for credit spreads and improve on both implied volatilities of index options and on historical volatilities when explaining the cross-sectional and time-series variation in a panel of corporate bond spreads. Both the level of individual implied volatilities and the implied-volatility skew matter for credit spreads. The empirical estimates are in line with the coefficients predicted by a theoretical structural firm value model. Importantly, detailed principal component analysis shows that our newly constructed determinants of credit spreads reverse the finding in
the literature that structural models leave a large part of the variation in credit spreads unexplained. Furthermore, our results indicate that option-market liquidity has a spillover effect on the short-maturity corporate bond market, and we show that individual option prices contain information on the likelihood of rating migrations.
JEL Classification: G12
Suggested Citation: Suggested Citation
Cremers, Martijn and Driessen, Joost and Maenhout, Pascal J. and Weinbaum, David, Individual Stock-Option Prices and Credit Spreads (December 2004). Yale ICF Working Paper No. 04-14; EFA 2004 Maastricht Meetings Paper No. 5147. Available at SSRN: https://ssrn.com/abstract=527502