Explaining the Level of Credit Spreads: Option-Implied Jump Risk Premia in a Firm Value Model

50 Pages Posted: 4 Mar 2005

See all articles by Martijn Cremers

Martijn Cremers

University of Notre Dame

Joost Driessen

Tilburg University - Center and Faculty of Economics and Business Administration; Tilburg University - Center for Economic Research (CentER)

Pascal J. Maenhout

INSEAD - Finance

Multiple version iconThere are 3 versions of this paper

Date Written: July 2006

Abstract

Prices of equity index put options contain information on the price of systematic downward jump risk. We use a structural jump-diffusion firm value model to assess the level of credit spreads that is generated by option-implied jump risk premia. In our compound option pricing model, an equity index option is an option on a portfolio of call options on the underlying firm values. We calibrate the model parameters to historical information on default risk, the equity premium and equity return distribution, and S&P 500 index option prices. Our results show that a model without jumps fails to fit the equity return distribution and option prices, and generates a low out-of-sample prediction for credit spreads. Adding jumps and jump risk premia improves the fit of the model in terms of equity and option characteristics considerably and brings predicted credit spread levels much closer to observed levels.

Keywords: Credit spreads, jump risk premium, firm value model

JEL Classification: G12, G13

Suggested Citation

Cremers, K. J. Martijn and Driessen, Joost and Maenhout, Pascal J., Explaining the Level of Credit Spreads: Option-Implied Jump Risk Premia in a Firm Value Model (July 2006). BIS Working Paper No. 191; EFA 2006 Zurich Meetings. Available at SSRN: https://ssrn.com/abstract=676420 or http://dx.doi.org/10.2139/ssrn.676420

K. J. Martijn Cremers (Contact Author)

University of Notre Dame ( email )

P.O. Box 399
Notre Dame, IN 46556-0399
United States

Joost Driessen

Tilburg University - Center and Faculty of Economics and Business Administration ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

Tilburg University - Center for Economic Research (CentER) ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

Pascal J. Maenhout

INSEAD - Finance ( email )

Boulevard de Constance
F-77305 Fontainebleau Cedex
France

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