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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. Drost, F.C. & Nijman, T.E. & Werker, B.J.M., 1994. "Estimation and testing in models containing both jumps and conditional heteroskedasticity," Discussion Paper 1994-105, Tilburg University, Center for Economic Research.
  2. Meddahi, Nour & Mykland, Per & Shephard, Neil, 2011. "Realized Volatility," Journal of Econometrics, Elsevier, vol. 160(1), pages 1-1, January.
  3. John Y. Campbell & Glen B. Taksler, 2002. "Equity Volatility and Corporate Bond Yields," NBER Working Papers 8961, National Bureau of Economic Research, Inc.
  4. Mella-Barral, Pierre & Perraudin, William, 1997. " Strategic Debt Service," Journal of Finance, American Finance Association, vol. 52(2), pages 531-56, June.
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Citations

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Cited by:
  1. Christopher Baum & Chi Wan, 2010. "Macroeconomic uncertainty and credit default swap spreads," Applied Financial Economics, Taylor & Francis Journals, vol. 20(15), pages 1163-1171.
  2. Landschoot, Astrid Van, 2008. "Determinants of yield spread dynamics: Euro versus US dollar corporate bonds," Journal of Banking & Finance, Elsevier, vol. 32(12), pages 2597-2605, December.
  3. Stuart M. Turnbull & Jun Yang, 2008. "Default Dependence: The Equity Default Relationship," Working Papers 08-1, Bank of Canada.
  4. repec:onb:oenbwp:y::i:152:b:1 is not listed on IDEAS
  5. Jing-zhi Huang & Hao Zhou, 2008. "Specification analysis of structural credit risk models," Finance and Economics Discussion Series 2008-55, Board of Governors of the Federal Reserve System (U.S.).
  6. Das, Sanjiv R. & Hanouna, Paul & Sarin, Atulya, 2009. "Accounting-based versus market-based cross-sectional models of CDS spreads," Journal of Banking & Finance, Elsevier, vol. 33(4), pages 719-730, April.
  7. Anderson, Ronald W & Carverhill, Andrew, 2007. "Liquidity and Capital Structure," CEPR Discussion Papers 6044, C.E.P.R. Discussion Papers.
  8. 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 1056, European Central Bank.
  9. 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, vol. 18(3), pages 259-271, July.
  10. Scheicher, Martin & Raunig, Burkhard, 2008. "A value at risk analysis of credit default swaps," Discussion Paper Series 2: Banking and Financial Studies 2008,12, Deutsche Bundesbank, Research Centre.
  11. George Tauchen & Hao Zhou, 2006. "Realized jumps on financial markets and predicting credit spreads," Finance and Economics Discussion Series 2006-35, Board of Governors of the Federal Reserve System (U.S.).
  12. Ronald W. Anderson & Andrew Carverhill, 2006. "Liquidity and capital structure," LSE Research Online Documents on Economics 24632, London School of Economics and Political Science, LSE Library.
  13. Hayette Gatfaoui, 2010. "Investigating the dependence structure between credit default swap spreads and the U.S. financial market," Annals of Finance, Springer, vol. 6(4), pages 511-535, October.

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