Credit default swap spreads and variance risk premia

Hao Wang, Hao Zhou and Yi Zhou

No 2011-02, Finance and Economics Discussion Series from Board of Governors of the Federal Reserve System (U.S.)

Abstract: We find that firm-level variance risk premium, estimated as the difference between option-implied and expected variances, has a prominent explanatory power for credit spreads in the presence of market- and firm-level risk control variables identified in the existing literature. Such a predictability complements that of the leading state variable--leverage ratio--and strengthens significantly with lower firm credit rating, longer credit contract maturity, and model-free implied variance. We provide further evidence that: (1) variance risk premium has a cleaner systematic component and Granger-causes implied and expected variances, (2) the cross-section of firms' variance risk premia seem to price the market variance risk correctly, and (3) a structural model with stochastic volatility can reproduce the predictability pattern of variance risk premia for credit spreads.

Keywords: Swaps (Finance); Risk (search for similar items in EconPapers)
Date: 2011
New Economics Papers: this item is included in nep-ban, nep-fmk, nep-mic and nep-rmg
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Citations: View citations in EconPapers (2)

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