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

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... Full description

1st Person: Zhang, Benjamin Yibin
Additional Persons: Zhou, Hao; Zhu, Haibin
Source: in The Review of Financial Studies Vol. 22, No. 12 (2009), p. 5099-5131
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Type of Publication: Article
Language: English
Published: 2009
Keywords: G12
G13
C14
Online: Volltext
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520 |a 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. 
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