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Explaining credit default swap spreads with equity volatility and jump risks of individual firms

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Author Info

  • Haibin Zhu
  • Benjamin Yibin Zhang

    (Fitch Ratings Inc.)

  • Hao Zhou

    (Federal Reserve Board - Risk Analysis Section)

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Abstract

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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Bibliographic Info

Paper provided by Bank for International Settlements in its series BIS Working Papers with number 181.

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Length: 45 pages
Date of creation: Sep 2005
Date of revision:
Handle: RePEc:bis:biswps:181

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Related research

Keywords: structural model; stochastic volatility; jumps; credit spread; credit default swap; nonlinear effect; high frequency data;

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References

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  1. John Y. Campbell & Glen B. Taksler, 2002. "Equity Volatility and Corporate Bond Yields," Harvard Institute of Economic Research Working Papers, Harvard - Institute of Economic Research 1945, Harvard - Institute of Economic Research.
  2. Meddahi, Nour & Mykland, Per & Shephard, Neil, 2011. "Realized Volatility," Journal of Econometrics, Elsevier, Elsevier, vol. 160(1), pages 1-1, January.
  3. Mella-Barral, Pierre & Perraudin, William, 1997. " Strategic Debt Service," Journal of Finance, American Finance Association, American Finance Association, vol. 52(2), pages 531-56, June.
  4. Drost, F.C. & Nijman, T.E. & Werker, B.J.M., 1994. "Estimation and testing in models containing both jumps and conditional heteroskedasticity," Discussion Paper, Tilburg University, Center for Economic Research 1994-105, Tilburg University, Center for Economic Research.
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Citations

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Cited by:
  1. Christopher F Baum & Chi Wan, 2009. "Macroeconomic Uncertainty and Credit Default Swap Spreads," Boston College Working Papers in Economics, Boston College Department of Economics 724, Boston College Department of Economics, revised 03 Mar 2010.
  2. Tauchen, George & Zhou, Hao, 2011. "Realized jumps on financial markets and predicting credit spreads," Journal of Econometrics, Elsevier, Elsevier, vol. 160(1), pages 102-118, January.
  3. Chen, Yi-Hsuan & Tu, Anthony H. & Wang, Kehluh, 2008. "Dependence structure between the credit default swap return and the kurtosis of the equity return distribution: Evidence from Japan," Journal of International Financial Markets, Institutions and Money, Elsevier, Elsevier, vol. 18(3), pages 259-271, July.
  4. Jing-zhi Huang & Hao Zhou, 2008. "Specification analysis of structural credit risk models," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 2008-55, Board of Governors of the Federal Reserve System (U.S.).
  5. Stuart M. Turnbull & Jun Yang, 2008. "Default Dependence: The Equity Default Relationship," Working Papers, Bank of Canada 08-1, Bank of Canada.
  6. Hayette Gatfaoui, 2010. "Investigating the dependence structure between credit default swap spreads and the U.S. financial market," Annals of Finance, Springer, Springer, vol. 6(4), pages 511-535, October.
  7. Ronald W. Anderson & Andrew Carverhill, 2006. "Liquidity and capital structure," LSE Research Online Documents on Economics, London School of Economics and Political Science, LSE Library 24632, London School of Economics and Political Science, LSE Library.
  8. Scheicher, Martin & Raunig, Burkhard, 2008. "A value at risk analysis of credit default swaps," Discussion Paper Series 2: Banking and Financial Studies, Deutsche Bundesbank, Research Centre 2008,12, Deutsche Bundesbank, Research Centre.
  9. Anderson, Ronald W & Carverhill, Andrew, 2007. "Liquidity and Capital Structure," CEPR Discussion Papers, C.E.P.R. Discussion Papers 6044, C.E.P.R. Discussion Papers.
  10. Das, Sanjiv R. & Hanouna, Paul & Sarin, Atulya, 2009. "Accounting-based versus market-based cross-sectional models of CDS spreads," Journal of Banking & Finance, Elsevier, Elsevier, vol. 33(4), pages 719-730, April.
  11. Fender, Ingo & Scheicher, Martin, 2009. "The pricing of subprime mortgage risk in good times and bad: evidence from the ABX.HE indices," Working Paper Series, European Central Bank 1056, European Central Bank.
  12. repec:onb:oenbwp:y::i:152:b:1 is not listed on IDEAS
  13. Landschoot, Astrid Van, 2008. "Determinants of yield spread dynamics: Euro versus US dollar corporate bonds," Journal of Banking & Finance, Elsevier, Elsevier, vol. 32(12), pages 2597-2605, December.

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