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Explaining the level of credit spreads: option-implied jump risk premia in a firm value model

  • Martijn Cremers

    (Yale School of Management)

  • Joost Driessen

    (University of Amsterdam Business School)

  • Pascal Maenhout

    (INSEAD - Finance)

  • David Weinbaum

    (Cornell University - Samuel Curtis Johnson Graduate School of Management)

Prices of equity index put options contain information on the price of systematic downward jump risk. We use a structural jump-diffusion firm value model to assess the level of credit spreads that is generated by option-implied jump risk premia. In our compound option pricing model, an equity index option is an option on a portfolio of call options on the underlying firm values. We calibrate the model parameters to historical information on default risk, the equity premium and equity return distribution, and S&P 500 index option prices. Our results show that a model without jumps fails to fit the equity return distribution and option prices, and generates a low out-of-sample prediction for credit spreads. Adding jumps and jump risk premia improves the fit of the model in terms of equity and option characteristics considerably and brings predicted credit spread levels much closer to observed levels.

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Paper provided by Bank for International Settlements in its series BIS Working Papers with number 191.

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Length: 51 pages
Date of creation: Nov 2005
Date of revision:
Handle: RePEc:bis:biswps:191
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  1. Rosenberg, Joshua V. & Engle, Robert F., 2002. "Empirical pricing kernels," Journal of Financial Economics, Elsevier, vol. 64(3), pages 341-372, June.
  2. 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.
  3. Bates, David S., 2003. "Empirical option pricing: a retrospection," Journal of Econometrics, Elsevier, vol. 116(1-2), pages 387-404.
  4. 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.
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