Credit Default Swap Spreads and Variance Risk Premium
25 Pages Posted: 1 Aug 2009 Last revised: 14 Nov 2022
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: Suggested Citation