The Information Content of Option-Implied Volatility for Credit Default Swap Valuation

FDIC Center for Financial Research, Working Paper No. 2007-08

38 Pages Posted: 11 Mar 2006 Last revised: 15 Nov 2012

Charles Cao

Pennsylvania State University

Zhaodong Zhong

Rutgers University

Fan Yu

Claremont McKenna College - Robert Day School of Economics and Finance

Date Written: September 9, 2009

Abstract

Credit default swaps (CDS) are similar to out-of-the-money put options in that both offer a low cost and effective protection against downside risk. This study investigates whether put option-implied volatility is an important determinant of CDS pricing. Using a large sample of firms with both CDS and options data, we find that individual firms' put option-implied volatility dominates historical volatility in explaining the time-series variation in CDS spreads. To understand this result, we show that implied volatility is a more efficient forecast for future realized volatility than historical volatility. More importantly, the volatility risk premium embedded in option prices covaries with the CDS spread. These findings complement existing empirical evidence based on market-level data.

Keywords: Credit default swap spread, option-implied volatility, volatility risk premium, informed trading

JEL Classification: G13, G14

Suggested Citation

Cao, Charles and Zhong, Zhaodong and Yu, Fan, The Information Content of Option-Implied Volatility for Credit Default Swap Valuation (September 9, 2009). FDIC Center for Financial Research, Working Paper No. 2007-08. Available at SSRN: https://ssrn.com/abstract=889867 or http://dx.doi.org/10.2139/ssrn.889867

Charles Cao

Pennsylvania State University ( email )

Department of Finance
Smeal College of Business
University Park, PA 16802
United States
814-865-7891 (Phone)
814-865-3362 (Fax)

HOME PAGE: http://www.personal.psu.edu/qxc2/cao.html

Zhaodong Zhong

Rutgers University ( email )

Department of Finance, Rutgers Business School
100 Rockafeller Road
Piscataway, NJ 08854
United States

Fan Yu (Contact Author)

Claremont McKenna College - Robert Day School of Economics and Finance ( email )

500 E. Ninth St.
Claremont, CA 91711-6420
United States
(909)607-3345 (Phone)

HOME PAGE: http://www.cmc.edu/academic/faculty/profile.asp?Fac=553

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