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Explaining credit default swap spreads with the equity volatility and jump risks of individual firms

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  • Benjamin Y. Zhang
  • Hao Zhou
  • Haibin Zhu

Abstract

A structural model with stochastic volatility and jumps implies specific relationships between observed equity returns and credit spreads. This paper explores such effects in the credit default swap (CDS) market. We use a novel approach to identify the realized jumps of individual equities from high frequency data. Our empirical results suggest that volatility risk alone predicts 50 percent of the variation in CDS spreads, while jump risk alone forecasts 19 percent. After controlling for credit ratings, macroeconomic conditions, and firms' balance sheet information, we can explain 77 percent of the total variation. Moreover, the pricing effects of volatility and jump measures vary consistently across investment-grade and high-yield entities. The estimated nonlinear effects of volatility and jumps are in line with the model-implied relationships between equity returns and credit spreads.

Suggested Citation

  • Benjamin Y. Zhang & Hao Zhou & Haibin Zhu, 2005. "Explaining credit default swap spreads with the equity volatility and jump risks of individual firms," Finance and Economics Discussion Series 2005-63, Board of Governors of the Federal Reserve System (U.S.).
  • Handle: RePEc:fip:fedgfe:2005-63
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    More about this item

    Keywords

    Swaps (Finance); Risk management; Econometric models;
    All these keywords.

    JEL classification:

    • C14 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Semiparametric and Nonparametric Methods: General
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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