Explaining credit default swap spreads with equity volatility and jump risks of individual firms
AbstractA 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 InfoPaper provided by Bank for International Settlements in its series BIS Working Papers with number 181.
Length: 45 pages
Date of creation: Sep 2005
Date of revision:
structural model; stochastic volatility; jumps; credit spread; credit default swap; nonlinear effect; high frequency data;
Find related papers by JEL classification:
- C14 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Semiparametric and Nonparametric Methods: General
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
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