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Explaining the Level of Credit Spreads: Option-Implied Jump Risk Premia in a Firm Value Model

  • K.J. Martijn Cremers
  • Joost Driessen
  • Pascal Maenhout

We study whether option-implied jump risk premia can explain the high observed level of credit spreads. We use a structural jump-diffusion firm value model to assess the level of credit spreads generated by option-implied jump risk premia. Prices and returns of equity index and individual options are used to estimate the jump parameters. We further calibrate the model to historical information on default risk and the equity premium. The results show that incorporating option-implied jump risk premia brings predicted credit spread levels much closer to observed levels. The introduction of jumps also helps to improve the fit of the volatility of credit spreads and equity returns. The Author 2008. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org, Oxford University Press.

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File URL: http://hdl.handle.net/10.1093/rfs/hhn071
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Article provided by Society for Financial Studies in its journal The Review of Financial Studies.

Volume (Year): 21 (2008)
Issue (Month): 5 (September)
Pages: 2209-2242

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Handle: RePEc:oup:rfinst:v:21:y:2008:i:5:p:2209-2242
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  1. Joshua Rosenberg & Robert F. Engle, 2000. "Empirical Pricing Kernels," New York University, Leonard N. Stern School Finance Department Working Paper Seires 99-014, New York University, Leonard N. Stern School of Business-.
  2. Bates, David S., 2003. "Empirical option pricing: a retrospection," Journal of Econometrics, Elsevier, vol. 116(1-2), pages 387-404.
  3. Buraschi, Andrea & Jackwerth, Jens, 2001. "The Price of a Smile: Hedging and Spanning in Option Markets," Review of Financial Studies, Society for Financial Studies, vol. 14(2), pages 495-527.
  4. Ait-Sahalia, Yacine & Wang, Yubo & Yared, Francis, 2001. "Do option markets correctly price the probabilities of movement of the underlying asset?," Journal of Econometrics, Elsevier, vol. 102(1), pages 67-110, May.
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