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

43 Pages Posted: 20 Sep 2007 Last revised: 18 Oct 2013

See all articles by Benjamin Yi-Bin Zhang

Benjamin Yi-Bin Zhang

UBS AG

Hao Zhou

SUSTech Business School; Tsinghua University - PBC School of Finance

Haibin Zhu

Bank for International Settlements (BIS)

Date Written: August 1, 2008

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 percent of the variation in CDS spread levels, whereas the jump risk alone forecasts 19 percent. After controlling for credit ratings, macroeconomic conditions, and firms' balance sheet information, we can explain 73 percent 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.

Keywords: Credit Default Swap, Credit Risk Premium, Stochastic Volatility, Jumps, Structural Model, Nonlinear Effect, High-Frequency Data

JEL Classification: G12, G13, C14

Suggested Citation

Zhang, Benjamin Yi-Bin and Zhou, Hao and Zhu, Haibin, Explaining Credit Default Swap Spreads With the Equity Volatility and Jump Risks of Individual Firms (August 1, 2008). Available at SSRN: https://ssrn.com/abstract=713482 or http://dx.doi.org/10.2139/ssrn.713482

Benjamin Yi-Bin Zhang

UBS AG ( email )

677 Washington Blvd
Stamford, CT 06901
United States
203-252-9986 (Phone)

Hao Zhou (Contact Author)

SUSTech Business School ( email )

1088 Xueyuan Avenue, Nanshan District
Southern University of Science and Technology
Shenzhen, Guangdong
China
+86-0755-88010464 (Phone)

Tsinghua University - PBC School of Finance ( email )

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Haidian District
Beijing, 100083
China
+86-10-62790655 (Phone)

Haibin Zhu

Bank for International Settlements (BIS) ( email )

Hong Kong
Hong Kong
852 2878 7145 (Phone)
852 2878 7123 (Fax)

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