Credit default swap spreads and variance risk premia
AbstractWe find that firm-level variance risk premium, estimated as the difference between option-implied and expected variances, has a prominent explanatory power for credit spreads in the presence of market- and firm-level risk control variables identified in the existing literature. Such a predictability complements that of the leading state variable--leverage ratio--and strengthens significantly with lower firm credit rating, longer credit contract maturity, and model-free implied variance. We provide further evidence that: (1) variance risk premium has a cleaner systematic component and Granger-causes implied and expected variances, (2) the cross-section of firms' variance risk premia seem to price the market variance risk correctly, and (3) a structural model with stochastic volatility can reproduce the predictability pattern of variance risk premia for credit spreads.
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Bibliographic InfoPaper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2011-02.
Date of creation: 2011
Date of revision:
This paper has been announced in the following NEP Reports:
- NEP-ALL-2011-02-05 (All new papers)
- NEP-BAN-2011-02-05 (Banking)
- NEP-FMK-2011-02-05 (Financial Markets)
- NEP-MIC-2011-02-05 (Microeconomics)
- NEP-RMG-2011-02-05 (Risk Management)
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