The Information Content of Option-Implied Volatility for Credit Default Swap Valuation

by Charles Cao of the Pennsylvania State University & China Center for Financial Research,
Fan Yu of the Claremont McKenna College, and
Zhaodong Zhong of the Rutgers University

September 9, 2009

Abstract: Credit default swaps (CDS) are similar to out-of-the-money put options in that both offer a low cost and effective protection against downside risk. This study investigates whether put option-implied volatility is an important determinant of CDS pricing. Using a large sample of firms with both CDS and options data, we find that individual firms' put option-implied volatility dominates historical volatility in explaining the time-series variation in CDS spreads. To understand this result, we show that implied volatility is a more efficient forecast for future realized volatility than historical volatility. More importantly, the volatility risk premium embedded in option prices covaries with the CDS spread. These findings complement existing empirical evidence based on market-level data.

JEL Classification: G11, G12, G14.

Keywords: Credit default swaps, Option implied volatility, Historical volatility, Price discovery, Volatility risk premium

Published in: Journal of Financial Markets, Vol. 13, No. 3, (August 2010), pp. 321-343.

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