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

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Author Info
Benjamin Yibin Zhang
Hao Zhou
Haibin Zhu

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Abstract

A structural model with stochastic volatility and jumps implies specific 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 equities from high frequency data. Our empirical results suggest that volatility risk alone predicts 50 percent of the variation in CDS spreads, while jump risk alone forecasts 19 percent. After controlling for credit ratings, macroeconomic conditions, and firms' balance sheet information, we can explain 77 percent of the total variation. Moreover, the pricing effects of volatility and jump measures vary consistently across investment-grade and 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 Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2005-63.

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Date of creation: 2005
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Handle: RePEc:fip:fedgfe:2005-63

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Keywords: Swaps (Finance) ; Risk management ; Econometric models;

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Anderson, Ronald W & Carverhill, Andrew, 2007. "Liquidity and Capital Structure," CEPR Discussion Papers 6044, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
  2. Torben G. Andersen & Luca Benzoni, 2008. "Realized volatility," Working Paper Series WP-08-14, Federal Reserve Bank of Chicago. [Downloadable!]
  3. Stuart M. Turnbull & Jun Yang, 2008. "Default Dependence: The Equity Default Relationship," Working Papers 08-1, Bank of Canada. [Downloadable!]
  4. Ingo Fender & Martin Scheicher, 2009. "Fiscal behaviour in the European Union - rules, fiscal decentralization and government indebtedness," Working Paper Series 1056, European Central Bank. [Downloadable!]
  5. 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.). [Downloadable!]
  6. Christopher F Baum & Chi Wan, 2009. "Macroeconomic Uncertainty and Credit Default Swap Spreads," Boston College Working Papers in Economics 724, Boston College Department of Economics. [Downloadable!]
  7. Kwamie Dunbar, 2007. "US Corporate Default Swap Valuation: The Market Liquidity Hypothesis and Autonomous Credit Risk," Working papers 2007-08, University of Connecticut, Department of Economics. [Downloadable!]
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