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

by Benjamin Yibin Zhang of Fitch Ratings,
Hao Zhou of the Federal Reserve Board, and
Haibin Zhu of the Bank for International Settlements

December 2006

Abstract: This paper tries 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 50 percent of the variation in CDS spread levels, while the jump risk alone forecasts 19 percent. After controlling for credit ratings, macroeconomic conditions, and firms' balance sheet information, we can explain 77 percent of the total variation. Moreover, the pricing effects of volatility and jump measures vary consistently across investment-grade and high-yield entities. The estimated nonlinear effects of volatility and jump risks on credit spreads are in line with the implications from a calibrated structural model with stochastic volatility and jumps, although the challenge of simultaneously matching credit spreads and default probabilities remains.

JEL Classification: G12, G13, C14.

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

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