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The information content of option-implied volatility for credit default swap valuation

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  • Cao, Charles
  • Yu, Fan
  • Zhong, Zhaodong
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    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 spreads. 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.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Financial Markets.

    Volume (Year): 13 (2010)
    Issue (Month): 3 (August)
    Pages: 321-343

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    Handle: RePEc:eee:finmar:v:13:y:2010:i:3:p:321-343

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    Web page: http://www.elsevier.com/locate/finmar

    Related research

    Keywords: Credit default swaps Option implied volatility Historical volatility Price discovery Volatility risk premium;

    References

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    Cited by:
    1. Sergio Mayordomo & Juan Ignacio Peña Sánchez de Rivera & Eduardo S. Schwartz, 2010. "Are all Credit Default Swap databases equal?," Business Economics Working Papers wb104621, Universidad Carlos III, Departamento de Economía de la Empresa.
    2. Cho-Hoi Hui & Tom Fong, 2011. "Information Flow between Sovereign CDS and Dollar-Yen Currency Option Markets in the Sovereign Debt Crisis of 2009-2011," Working Papers 402011, Hong Kong Institute for Monetary Research.
    3. Hui, Cho-Hoi & Chung, Tsz-Kin, 2011. "Crash risk of the euro in the sovereign debt crisis of 2009-2010," Journal of Banking & Finance, Elsevier, vol. 35(11), pages 2945-2955, November.
    4. Avino, Davide & Lazar, Emese & Varotto, Simone, 2012. "Price Discovery of Credit Spreads in Tranquil and Crisis Periods," MPRA Paper 42847, University Library of Munich, Germany.
    5. Avino, Davide & Nneji, Ogonna, 2012. "Are CDS spreads predictable? An analysis of linear and non-linear forecasting models," MPRA Paper 42848, University Library of Munich, Germany.
    6. Sergio Mayordomo & Juan Ignacio Peña & Eduardo S. Schwartz, 2010. "Are all Credit Default Swap Databases Equal?," NBER Working Papers 16590, National Bureau of Economic Research, Inc.
    7. Kitty Moloney & Srinivas Raghavendra, 2010. "Quantitative Risk Estimation in the Credit Default Swap Market using Exteme Value Theory," Working Papers 0158, National University of Ireland Galway, Department of Economics, revised 2010.

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