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Option-Based Credit Spreads


  • Culp, Christopher L.
  • Nozawa, Yoshio
  • Veronesi, Pietro


Theoretically, corporate debt is economically equivalent to safe debt minus a put option on the firm’s assets. We empirically show that indeed portfolios of long Treasuries and short traded put options ("pseudo bonds") closely match the properties of traded corporate bonds. Pseudo bonds display a credit spread puzzle that is stronger at short horizons, unexplained by standard risk factors, and unlikely to be solely due to illiquidity. Our option-based approach also offers a novel, model-free benchmark for credit risk analysis, which we use to run empirical experiments on credit spread biases, the impact of asset uncertainty, and bank-related rollover risk.

Suggested Citation

  • Culp, Christopher L. & Nozawa, Yoshio & Veronesi, Pietro, 2014. "Option-Based Credit Spreads," CEPR Discussion Papers 10318, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:10318

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    References listed on IDEAS

    1. Francis A. Longstaff & Sanjay Mithal & Eric Neis, 2005. "Corporate Yield Spreads: Default Risk or Liquidity? New Evidence from the Credit Default Swap Market," Journal of Finance, American Finance Association, vol. 60(5), pages 2213-2253, October.
    2. Hui Chen, 2010. "Macroeconomic Conditions and the Puzzles of Credit Spreads and Capital Structure," Journal of Finance, American Finance Association, vol. 65(6), pages 2171-2212, December.
    3. Shiller, Robert J, 1981. "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?," American Economic Review, American Economic Association, vol. 71(3), pages 421-436, June.
    4. Hayne E. Leland, 1998. "Agency Costs, Risk Management, and Capital Structure," Journal of Finance, American Finance Association, vol. 53(4), pages 1213-1243, August.
    5. John H. Cochrane, 2008. "The Dog That Did Not Bark: A Defense of Return Predictability," Review of Financial Studies, Society for Financial Studies, vol. 21(4), pages 1533-1575, July.
    6. Yu, Fan, 2005. "Accounting transparency and the term structure of credit spreads," Journal of Financial Economics, Elsevier, vol. 75(1), pages 53-84, January.
    7. Peter Carr & Liuren Wu, 2011. "A Simple Robust Link Between American Puts and Credit Protection," Review of Financial Studies, Society for Financial Studies, vol. 24(2), pages 473-505.
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    Cited by:

    1. Schneider, Paul & Wagner, Christian & Zechner, Josef, 2016. "Low risk anomalies?," CFS Working Paper Series 550, Center for Financial Studies (CFS).
    2. Sang Byung Seo & Jessica A. Wachter, 2016. "Do Rare Events Explain CDX Tranche Spreads?," NBER Working Papers 22723, National Bureau of Economic Research, Inc.

    More about this item


    credit spreads; default; Merton model; options;

    JEL classification:

    • G1 - Financial Economics - - General Financial Markets
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
    • G3 - Financial Economics - - Corporate Finance and Governance

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