Credit Default Swap Spreads and Variance Risk Premium

25 Pages Posted: 1 Aug 2009 Last revised: 14 Nov 2022

See all articles by Hao Wang

Hao Wang

Tsinghua University

Hao Zhou

Tsinghua University - PBC School of Finance; SUSTech Business School

Yi Zhou

San Francisco State University

Date Written: August 1, 2009

Abstract

Variance risk premium (VRP), estimated by the difference between option implied variance and expected variance, captures the market consensus of risk arising from time-varying economic uncertainties. In this paper, we examine the dynamic relationship between VRP and credit default swap (CDS) spreads. We expect to find that VRP has prominent predictability on CDS spreads at individual firm level. Such predictability cannot be crowded out by that of the market and firm level credit risk factors identified in previous research. Our study presents important economic explanations to the predictability of option-implied variance on credit spreads. In particular, we demonstrate to what extent such predictability comes from risk premium changes and from variance risk shocks. Our investigation on both the inter-temporal and cross-sectional patterns of the VRP-CDS relationship helps to identify the optimal time to predict the movements of CDS spreads using combined information from liquid option and equity markets, and to understand the interactions of the VRP-CDS relationship with market conditions and firm characteristics. Our findings shed light on the credit risk puzzle and provide implications for theoretical research in improving credit risk modeling.

Keywords: Variance Risk Premium, Credit Default Swap Spreads, Option-implied Variance, Expected Variance, Realized Variance

JEL Classification: G12

Suggested Citation

Wang, Hao and Zhou, Hao and Zhou, Yi, Credit Default Swap Spreads and Variance Risk Premium (August 1, 2009). Available at SSRN: https://ssrn.com/abstract=1442445 or http://dx.doi.org/10.2139/ssrn.1442445

Hao Wang (Contact Author)

Tsinghua University ( email )

318 Weilun Building
Tsinghua University
Beijing, 100084
China
86 10 62797482 (Phone)
86 10 62794554 (Fax)

Hao Zhou

Tsinghua University - PBC School of Finance ( email )

No. 43, Chengfu Road
Haidian District
Beijing, 100083
China
+86-10-62790655 (Phone)

SUSTech Business School ( email )

1088 Xueyuan Avenue, Nanshan District
Southern University of Science and Technology
Shenzhen, Guangdong 518055
China

Yi Zhou

San Francisco State University ( email )

College of Business
1600 Holloway Avenue
San Francisco, CA 94132
United States
(415) 338-2661 (Phone)
(415) 338-0596 (Fax)

HOME PAGE: http://cob.sfsu.edu/directory/yi-zhou

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