A structural model with stochastic volatility and jumps implies particular relationships between observed equity returns and credit spreads. This paper explores such effects in the credit default swap (CDS) market. We use a novel approach to identify the realized jumps of individual equity from high frequency data. Our empirical results suggest that volatility risk alone predicts 50% of CDS spread variation, while jump risk alone forecasts 19%. After controlling for credit ratings, macroeconomic conditions, and firms' balance sheet information, we can explain 77% of the total variation. Moreover, the marginal impacts of volatility and jump measures increase dramatically from investment grade to high-yield entities. The estimated nonlinear effects of volatility and jumps are in line with the model implied relationships between equity returns and credit spreads.
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Paper provided by Bank for International Settlements in its series BIS Working Papers with number
181.
Find related papers by JEL classification: C14 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: General - - - Semiparametric and Nonparametric Methods G12 - Financial Economics - - General Financial Markets - - - Asset Pricing G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
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