Credit Default Swap Spreads and Variance Risk Premia

43 Pages Posted: 11 Nov 2011

See all articles by Hao Zhou

Hao Zhou

Tsinghua University - PBC School of Finance; SUSTech Business School

wang hao

affiliation not provided to SSRN

Zhou Yi

affiliation not provided to SSRN

Multiple version iconThere are 3 versions of this paper

Date Written: October 10, 2010

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: Variance risk premia, credit default swap spreads, option-implied variance, expected variance, realized variance

JEL Classification: G12, G13, G14

Suggested Citation

Zhou, Hao and hao, wang and Yi, Zhou, Credit Default Swap Spreads and Variance Risk Premia (October 10, 2010). FEDS Working Paper No. 2011-02, Available at SSRN: https://ssrn.com/abstract=1957780 or http://dx.doi.org/10.2139/ssrn.1957780

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

Wang Hao

affiliation not provided to SSRN ( email )

Zhou Yi (Contact Author)

affiliation not provided to SSRN ( email )

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