Review of Financial Studies Vol. 22 No. 12 2009

Explaining Credit Default Swap Spreads with the Equity Volatility and Jump Risks of Individual Firms

Benjamin Yibin Zhang¹; Hao Zhou²; Haibin Zhu³

¹ UBS-Global Credit Strategies · ² Federal Reserve Board of Governors · ³ Bank for International Settlements

Abstract

This paper attempts to explain the credit default swap (CDS) premium, using a novel approach to identify the volatility and jump risks of individual firms from high-frequency equity prices. Our empirical results suggest that the volatility risk alone predicts 48% of the variation in CDS spread levels, whereas the jump risk alone forecasts 19%. After controlling for credit ratings, macroeconomic conditions, and firms' balance sheet information, we can explain 73% of the total variation. We calibrate a Merton-type structural model with stochastic volatility and jumps, which can help to match credit spreads after controlling for the historical default rates. Simulation evidence suggests that the high-frequency-based volatility measures can help to explain the credit spreads, above and beyond what is already captured by the true leverage ratio.

DOI

10.1093/rfs/hhp004

Volume

22

Issue

12

Pages

5099-5131

Language

en

Sources

openalex crossref