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Credit-implied forward volatility and volatility expectations

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  • Byström, Hans

Abstract

We show how one can back out implied forward volatility term structures from credit default swap spreads. Such forward stock volatility term structures are useful for instance in forward start option pricing. We find the term structure to be downward-sloping, and the credit market's volatility forecasts tend to vary more across time than across maturities. Long-term volatility expectations, in turn, are found to be low and stable while short-term expectations are higher and more volatile. The volatility expectation's mean-reversion rate, finally, indicates that the credit market expects volatility shocks in the equity market to last for several years.

Suggested Citation

  • Byström, Hans, 2016. "Credit-implied forward volatility and volatility expectations," Finance Research Letters, Elsevier, vol. 16(C), pages 132-138.
  • Handle: RePEc:eee:finlet:v:16:y:2016:i:c:p:132-138
    DOI: 10.1016/j.frl.2015.10.027
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    References listed on IDEAS

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    1. Mixon, Scott, 2007. "The implied volatility term structure of stock index options," Journal of Empirical Finance, Elsevier, vol. 14(3), pages 333-354, June.
    2. Heynen, Ronald & Kemna, Angelien & Vorst, Ton, 1994. "Analysis of the Term Structure of Implied Volatilities," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 29(1), pages 31-56, March.
    3. Stein, Jeremy, 1989. " Overreactions in the Options Market," Journal of Finance, American Finance Association, vol. 44(4), pages 1011-1023, September.
    4. Xu, Xinzhong & Taylor, Stephen J., 1994. "The Term Structure of Volatility Implied by Foreign Exchange Options," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 29(1), pages 57-74, March.
    5. Byström, Hans, 2013. "Stock Prices and Stock Return Volatilities Implied by the Credit Market," Working Papers 2013:25, Lund University, Department of Economics, revised 14 Feb 2014.
    6. Campa, Jose Manuel & Chang, P H Kevin, 1995. "Testing the Expectations Hypothesis on the Term Structure of Volatilities in Foreign Exchange Options," Journal of Finance, American Finance Association, vol. 50(2), pages 529-547, June.
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    More about this item

    Keywords

    CDS; Implied volatility term structure; Forward volatility; Forward start options;

    JEL classification:

    • G1 - Financial Economics - - General Financial Markets
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation
    • G53 - Financial Economics - - Household Finance - - - Financial Literacy

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