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## The Information Content of Option-Implied Volatility for Credit Default Swap Valuation. Working Paper (2005)

Citations: | 39 - 0 self |

### Citations

2243 | On the pricing of corporate debt: the risk structure of interest rates - Merton - 1974 |

644 | Valuing Corporate Securities: Some Effects of Bond Indenture Provisions - Black, Cox - 1976 |

532 | Optimal capital structure, endogenous bankruptcy, and the term structure of credit spreads. - Leland, Toft - 1996 |

420 | The determinants of credit spread changes.
- Collin-Dufresne, Goldstein, et al.
- 2001
(Show Context)
Citation Context ...e payoff from the seller, should a credit event occur prior to the expiration of the contract. Fueled by the eagerness of banks, insurance companies, and hedge funds to take on or shed credit risk exposures, the CDS market has been growing exponentially during the past decade, reaching $62 trillion in notional amount outstanding by the end of 2007.1 This dramatic development obviates the need for a better understanding of the valuation of credit risk. In response, a recent strand of literature has recognized the important role of firmlevel volatility in the determination of CDS spreads (e.g., Collin-Dufresne et al., 2001; Ericsson et al., 2009; Zhang et al., 2009). Considering that credit default swaps share similar payoff characteristics with certain types of options (e.g., out-of-the-money puts) in that both offer a low cost and effective protection against downside risk, we conduct a comprehensive analysis of the relation between CDS spreads and option-implied volatilities.2 The rationale for relying ARTICLE IN PRESS Sp re ad AT&T Fig. 1. AT&T CDS spreads. This figure plots the time-series of CDS spreads of AT&T Corp. from January 2001 to June 2005 before it was acquired by SBC. CDS Spread is the market CD... |

380 | Explaining the rate spread on corporate bonds. - Elton, Gruber, et al. - 2001 |

358 | Corporate yield spreads: Default risk or liquidity? new evidence from the credit default swap market
- Longstaff, Mithal, et al.
- 2005
(Show Context)
Citation Context ...y rate (%) 3.93 3.28 3.96 4.57 0.74 Yield curve slope (%) 1.30 0.32 1.61 2.12 0.92 Credit market illiquidity (%) 0.54 0.44 0.50 0.66 0.13 Baa rate (%) 6.90 6.26 6.69 7.80 0.75 C. Cao et al. / Journal of Financial Markets 13 (2010) 321–343328 Author's personal copy Among the market variables, we observe negative coefficients for the Treasury term structure level and slope. This is consistent with the evidence from corporate bond yield spreads (Duffee, 1998). The coefficient of the Baa yield is positive and significant, which can be attributed to the close relation between bond and CDS markets (Longstaff et al., 2005; Blanco et al., 2005). The coefficient of the credit market illiquidity factor is positive and significant, consistent with the ‘‘flight-to-quality’’ interpretation of the Feldhutter and Lando (2008) Treasury convenience yield factor. Lastly, none of the market volatility variables is significant, which suggests that the information content of market-level volatilities is subsumed by firm-level volatilities. With this list of additional variables included in the regressions, the average R2 of the time-series regressions has increased from 55% in Regression 1 to 84% in Regression 4. ARTICLE I... |

316 | Term structure of credit spreads with incomplete accounting information. - Duffie, Lando - 2001 |

303 |
A Simple Positive Semi-Definite, Heteroscedasticity,
- Newey, West
- 1987
(Show Context)
Citation Context ...e the latter has only 47% such cases. We also conduct a one-sided test of whether the implied volatility coefficient ðb2Þ is greater than the historical volatility coefficient ðb1Þ. In ARTICLE IN PRESS Table 3 Time-series regression analysis of CDS spreads. Cross-sectional averages of coefficients, t-statistics (in parentheses), and adjusted R-squares of time-series regressions for 301 sample firms. For each firm and each time-series regression, the dependent variable is the daily five-year composite credit default swap spread. The definitions of independent variables are provided in Table 1. Newey and West (1987) standard errors (with five lags) are used to compute t-statistics. The sample period extends from January 2001 through December 2006. 1 2 3 4 Intercept 82.73 192.71 177.84 340.77 (6.09) (5.99) (5.15) (5.20) Historical volatility ðb1Þ 1.08 0.92 0.60 0.69 (3.53) (2.58) (1.89) (1.82) Implied volatility ðb2Þ 4.26 2.93 2.81 2.01 (8.01) (6.08) (4.84) (3.07) Additional firm-specific variables Implied volatility skew 8.68 7.17 5.09 (1.12) (0.81) (0.53) Leverage 2.80 2.46 3.64 (4.71) (3.38) (2.63) Firm stock return 0.02 0.03 0.00 (0.12) (0.21) (0.12) Market volatility variables Market his... |

245 | Structural models of corporate bond pricing: An empirical analysis. Review of Financial Studies, - Eom, Helwege, et al. - 2004 |

229 | Contingent Claim Analysis of Corporate Capital Structures: An Empirical Investigation - Jones, Mason, et al. - 1984 |

222 | The Relation between Treasury Yields and Corporate Bond Yield Spreads
- Duffee
- 1998
(Show Context)
Citation Context ...olatility (%) 17.61 11.89 15.98 21.11 6.88 Market implied volatility skew 0.77 0.65 0.75 0.88 0.18 Market return (%) 3.17 12.47 7.67 13.87 16.11 Treasury rate (%) 3.93 3.28 3.96 4.57 0.74 Yield curve slope (%) 1.30 0.32 1.61 2.12 0.92 Credit market illiquidity (%) 0.54 0.44 0.50 0.66 0.13 Baa rate (%) 6.90 6.26 6.69 7.80 0.75 C. Cao et al. / Journal of Financial Markets 13 (2010) 321–343328 Author's personal copy Among the market variables, we observe negative coefficients for the Treasury term structure level and slope. This is consistent with the evidence from corporate bond yield spreads (Duffee, 1998). The coefficient of the Baa yield is positive and significant, which can be attributed to the close relation between bond and CDS markets (Longstaff et al., 2005; Blanco et al., 2005). The coefficient of the credit market illiquidity factor is positive and significant, consistent with the ‘‘flight-to-quality’’ interpretation of the Feldhutter and Lando (2008) Treasury convenience yield factor. Lastly, none of the market volatility variables is significant, which suggests that the information content of market-level volatilities is subsumed by firm-level volatilities. With this list of additi... |

222 | Estimating the price of default risk. - Duffee - 1999 |

213 |
The Relation Between Implied and Realized Volatility,”
- Christensen, Prabhala
- 1998
(Show Context)
Citation Context ...ining the time-series variation of CDS spreads. Probing deeper into the nature of the information content of option-implied volatility, we focus on the following question: Does implied volatility explain the time-series behavior of CDS spreads because it forecasts future volatility better, or because it captures a volatility risk premium? For the first part of this question, the extant literature has examined the power of implied volatility to predict future realized volatility, producing generally mixed evidence (Day and Lewis, 1992; Canina and Figlewski, 1993; Lamoureux and Lastrapes, 1993; Christensen and Prabhala, 1998; Jiang and Tian, 2005). As for the second part of the question, the difference between implied volatility and the expected future volatility under the objective measure is commonly regarded as a volatility risk premium (Bakshi and Kapadia, 2003; Bates, 2003; Chernov, 2007; Bollerslev et al., 2008, 2009; Zhou, 2009). Because of the similarity between the payoffs of out-of-the-money puts and credit default swaps, this risk premium component can, presumably, help to explain CDS spreads in a way that even the best volatility estimator cannot. To address this important question, we first analyze t... |

202 | The link between default and recovery rates: Theory, empirical evidence, and implications.
- Altman, Brady, et al.
- 2003
(Show Context)
Citation Context ...ead (IV) is the spread computed by a structural model (CreditGrades) using the option-implied volatility as input. Model Spread (HV) is the spread computed by the CreditGrades model using the 252-day historical volatility as input. 1See the International Swaps and Derivatives Association 2007 year-end market survey. 2There is, however, one important difference. Conditional on default, the CDS payoff is related to the recovery rate of the underlying obligation, while the put payoff is equal to the strike price (assuming a stock price of zero). To the extent that recovery risk is macroeconomic (Altman et al., 2003), the effect of recovery risk on CDS spreads is partially addressed by the list of macroeconomic variables included in our analysis. C. Cao et al. / Journal of Financial Markets 13 (2010) 321–343322 Author's personal copy on implied volatility as an important explanatory variable for the time-series behavior of CDS spreads is also evident from Fig. 1, where we fit an industry benchmark credit risk model called CreditGrades to AT&T CDS spreads, using either the 252-day historical volatility or the put option-implied volatility. This figure shows that the use of implied volatility yields a much ... |

190 | An Empirical Analysis of the Dynamic Relationship between Investment-Grade Bonds and Credit Default Swaps,”
- Blanco, Brennan, et al.
- 2005
(Show Context)
Citation Context ...6 4.57 0.74 Yield curve slope (%) 1.30 0.32 1.61 2.12 0.92 Credit market illiquidity (%) 0.54 0.44 0.50 0.66 0.13 Baa rate (%) 6.90 6.26 6.69 7.80 0.75 C. Cao et al. / Journal of Financial Markets 13 (2010) 321–343328 Author's personal copy Among the market variables, we observe negative coefficients for the Treasury term structure level and slope. This is consistent with the evidence from corporate bond yield spreads (Duffee, 1998). The coefficient of the Baa yield is positive and significant, which can be attributed to the close relation between bond and CDS markets (Longstaff et al., 2005; Blanco et al., 2005). The coefficient of the credit market illiquidity factor is positive and significant, consistent with the ‘‘flight-to-quality’’ interpretation of the Feldhutter and Lando (2008) Treasury convenience yield factor. Lastly, none of the market volatility variables is significant, which suggests that the information content of market-level volatilities is subsumed by firm-level volatilities. With this list of additional variables included in the regressions, the average R2 of the time-series regressions has increased from 55% in Regression 1 to 84% in Regression 4. ARTICLE IN PRESS Table 2 Sample... |

190 |
The information content of implied volatility.
- Canina, Figlewski
- 1993
(Show Context)
Citation Context ... with a special role of options market information in explaining the time-series variation of CDS spreads. Probing deeper into the nature of the information content of option-implied volatility, we focus on the following question: Does implied volatility explain the time-series behavior of CDS spreads because it forecasts future volatility better, or because it captures a volatility risk premium? For the first part of this question, the extant literature has examined the power of implied volatility to predict future realized volatility, producing generally mixed evidence (Day and Lewis, 1992; Canina and Figlewski, 1993; Lamoureux and Lastrapes, 1993; Christensen and Prabhala, 1998; Jiang and Tian, 2005). As for the second part of the question, the difference between implied volatility and the expected future volatility under the objective measure is commonly regarded as a volatility risk premium (Bakshi and Kapadia, 2003; Bates, 2003; Chernov, 2007; Bollerslev et al., 2008, 2009; Zhou, 2009). Because of the similarity between the payoffs of out-of-the-money puts and credit default swaps, this risk premium component can, presumably, help to explain CDS spreads in a way that even the best volatility estimator... |

189 | Equity volatility and corporate bond yields
- Campbell, Taksler
- 2003
(Show Context)
Citation Context ...0) 321–343 323 Author's personal copy predicted future volatility. We then regress the CDS spread on the predicted future volatility and the volatility risk premium. We find the volatility risk premium to be a significant determinant of CDS spreads even in the presence of the predicted future volatility. Taken together, these results suggest that the ability of implied volatility to explain CDS spreads stems from a combination of better prediction of future volatility and the volatility risk premium embedded in option prices. Our paper contributes to the extant literature in a number of ways. Campbell and Taksler (2003), Ericsson et al. (2009) and Zhang et al. (2009) have demonstrated a strong relation between credit spreads and equity historical volatilities. We focus instead on the relation between CDS spreads and options market information and show that option-implied volatility is an even more important determinant of CDS spreads than equity historical volatility. Cremers et al. (2008) estimate the relation between corporate bond yield spreads and options market variables. They adopt a panel regression approach, which relies on information from the cross-section of firms for identification. Motivated by ... |

184 | The relationship between credit default swap spreads, bond yields, and credit rating announcements - Hull, Predescu, et al. - 2004 |

173 |
Stock market volatility and the information content of stock index options.
- Day, Lewis
- 1992
(Show Context)
Citation Context ...ndings are consistent with a special role of options market information in explaining the time-series variation of CDS spreads. Probing deeper into the nature of the information content of option-implied volatility, we focus on the following question: Does implied volatility explain the time-series behavior of CDS spreads because it forecasts future volatility better, or because it captures a volatility risk premium? For the first part of this question, the extant literature has examined the power of implied volatility to predict future realized volatility, producing generally mixed evidence (Day and Lewis, 1992; Canina and Figlewski, 1993; Lamoureux and Lastrapes, 1993; Christensen and Prabhala, 1998; Jiang and Tian, 2005). As for the second part of the question, the difference between implied volatility and the expected future volatility under the objective measure is commonly regarded as a volatility risk premium (Bakshi and Kapadia, 2003; Bates, 2003; Chernov, 2007; Bollerslev et al., 2008, 2009; Zhou, 2009). Because of the similarity between the payoffs of out-of-the-money puts and credit default swaps, this risk premium component can, presumably, help to explain CDS spreads in a way that even t... |

170 | Option volume and stock prices: Evidence on where informed traders trade - Easley, O’Hara, et al. - 1998 |

151 |
Forecasting Stock-Return Variance: Toward an Understanding of Stochastic Implied Volatilities,”
- Lamoureux, Lastrapes
- 1993
(Show Context)
Citation Context ...ons market information in explaining the time-series variation of CDS spreads. Probing deeper into the nature of the information content of option-implied volatility, we focus on the following question: Does implied volatility explain the time-series behavior of CDS spreads because it forecasts future volatility better, or because it captures a volatility risk premium? For the first part of this question, the extant literature has examined the power of implied volatility to predict future realized volatility, producing generally mixed evidence (Day and Lewis, 1992; Canina and Figlewski, 1993; Lamoureux and Lastrapes, 1993; Christensen and Prabhala, 1998; Jiang and Tian, 2005). As for the second part of the question, the difference between implied volatility and the expected future volatility under the objective measure is commonly regarded as a volatility risk premium (Bakshi and Kapadia, 2003; Bates, 2003; Chernov, 2007; Bollerslev et al., 2008, 2009; Zhou, 2009). Because of the similarity between the payoffs of out-of-the-money puts and credit default swaps, this risk premium component can, presumably, help to explain CDS spreads in a way that even the best volatility estimator cannot. To address this import... |

138 | Stock Return Characteristics, Skew Laws,
- Bakshi, Kapadia, et al.
- 2003
(Show Context)
Citation Context ...the implied volatility (IV ) and the 252-day historical volatility (HV), as well as additional control ARTICLE IN PRESS 4We are grateful to Peter Feldhutter and David Lando for sharing their Treasury convenience yield factor. Since our credit market illiquidity measure is constructed using a parametric model of the swap-Treasury spread (i.e., Feldhutter and Lando, 2008), in Section 5 we explore alternative measures of credit market illiquidity that are model-independent. These include the swap-Treasury spread itself, as well as the spread between on- and offthe-run 10-year Treasury yields. 5Bakshi et al. (2003) offer similar findings on the implied volatility skew for index and individual stock options. C. Cao et al. / Journal of Financial Markets 13 (2010) 321–343 327 Author's personal copy variables described in Section 2: CDSt aþ b1HVt þ b2IV t þ additional firm2specific variables þmarket volatility variablesþmacro variablesþ et: ð1Þ First, we find that the effect of these additional control variables on the CDS spread, if any, is consistent with theoretical predictions and the extant empirical evidence. Table 3 shows that the average coefficient of the firm-implied volatility skew is positive.... |

133 | Predicting volatility in the foreign exchange market. - Jorion - 1995 |

132 | Default and Recovery Implicit in the Term Structure of Sovereign CDS Spreads
- Pan, Singleton
- 2008
(Show Context)
Citation Context ...ng power of the volatility risk premium for market-level risk premiums and credit spreads. For example, Bollerslev et al. (2009) and Zhou (2009) develop a general equilibrium model that incorporates the effect of time-varying economic uncertainties. They construct the volatility risk premium from the model-free implied volatility and the high-frequency realized volatility, and show that it can forecast (1) returns on the S&P 500 index; (2) returns on Treasury bonds; and (3) Moody’s Aaa and Baa corporate bond spreads. These empirical results are consistent with the implications of their model. Pan and Singleton (2008) extract the credit risk premium from sovereign CDS spreads and find that it covaries with the VIX index, which embeds the volatility risk premium. Our work extends this literature to the important single-name credit default swaps market and volatility risk premiums extracted from individual firms’ stock options. The rest of this paper is organized as follows. In Section 2, we summarize the data sources and variables used in our study. In Section 3, we conduct a regression-based analysis of the relation between the CDS and options markets. Section 4 examines the role of the volatility risk pre... |

122 | Expected Stock Returns and Variance Risk Premium.” Review of Financial Studies
- BOLLERSLEV, TAUCHEN, et al.
- 2009
(Show Context)
Citation Context ... of implied volatility. In particular, Lamoureux and Lastrapes (1993) use a sample of 10 firms to show that implied volatility is a biased forecast for future volatility, and they suggest that this bias can be attributed to a volatility risk premium. We extend their analysis to a sample of 301 firms. Our results show that the volatility risk premium is highly relevant when explaining the pricing of credit default swaps. Our paper is also related to recent literature documenting the forecasting power of the volatility risk premium for market-level risk premiums and credit spreads. For example, Bollerslev et al. (2009) and Zhou (2009) develop a general equilibrium model that incorporates the effect of time-varying economic uncertainties. They construct the volatility risk premium from the model-free implied volatility and the high-frequency realized volatility, and show that it can forecast (1) returns on the S&P 500 index; (2) returns on Treasury bonds; and (3) Moody’s Aaa and Baa corporate bond spreads. These empirical results are consistent with the implications of their model. Pan and Singleton (2008) extract the credit risk premium from sovereign CDS spreads and find that it covaries with the VIX index... |

104 | The Determinants of Credit Default Swap Premia,” working paper,
- Ericsson, Jacobs, et al.
- 2004
(Show Context)
Citation Context ...ld a credit event occur prior to the expiration of the contract. Fueled by the eagerness of banks, insurance companies, and hedge funds to take on or shed credit risk exposures, the CDS market has been growing exponentially during the past decade, reaching $62 trillion in notional amount outstanding by the end of 2007.1 This dramatic development obviates the need for a better understanding of the valuation of credit risk. In response, a recent strand of literature has recognized the important role of firmlevel volatility in the determination of CDS spreads (e.g., Collin-Dufresne et al., 2001; Ericsson et al., 2009; Zhang et al., 2009). Considering that credit default swaps share similar payoff characteristics with certain types of options (e.g., out-of-the-money puts) in that both offer a low cost and effective protection against downside risk, we conduct a comprehensive analysis of the relation between CDS spreads and option-implied volatilities.2 The rationale for relying ARTICLE IN PRESS Sp re ad AT&T Fig. 1. AT&T CDS spreads. This figure plots the time-series of CDS spreads of AT&T Corp. from January 2001 to June 2005 before it was acquired by SBC. CDS Spread is the market CDS spread provided by Ma... |

103 |
Fact and fantasy in the use of options.
- Black
- 1975
(Show Context)
Citation Context ...preads. On the other hand, short-horizon (e.g., 22-day) historical volatilities may be more attuned to marketmoving news, but they are far too noisy to yield any improvement over the information content of implied volatility. We therefore conclude that the information advantage of implied volatility is robust to historical volatility estimators of different horizons. 5.4. Sub-sample results Because our sample consists of a broad cross-section of firms, we can analyze how the information content of implied volatility for CDS pricing depends on important firm-level characteristics. According to Black (1975), Back (1993), Easley et al. (1998), and others, implied volatility is likely to be informative when the options have sufficient leverage and liquidity, as well as when the amount of information asymmetry in the options market is high. Recent empirical studies, such as Cao et al. (2005) and Pan and Poteshman (2006), have tested these predictions by examining the predictive power of the option volume for future stock returns. ARTICLE IN PRESS C. Cao et al. / Journal of Financial Markets 13 (2010) 321–343 337 Author's personal copy To the extent that options market liquidity is proxied by open i... |

97 |
Empirical Option Pricing: A Retrospection,”
- Bates
- 2003
(Show Context)
Citation Context ...ility better, or because it captures a volatility risk premium? For the first part of this question, the extant literature has examined the power of implied volatility to predict future realized volatility, producing generally mixed evidence (Day and Lewis, 1992; Canina and Figlewski, 1993; Lamoureux and Lastrapes, 1993; Christensen and Prabhala, 1998; Jiang and Tian, 2005). As for the second part of the question, the difference between implied volatility and the expected future volatility under the objective measure is commonly regarded as a volatility risk premium (Bakshi and Kapadia, 2003; Bates, 2003; Chernov, 2007; Bollerslev et al., 2008, 2009; Zhou, 2009). Because of the similarity between the payoffs of out-of-the-money puts and credit default swaps, this risk premium component can, presumably, help to explain CDS spreads in a way that even the best volatility estimator cannot. To address this important question, we first analyze the predictability of future realized volatility using historical and/or implied volatility. When included alone in the firm-level predictive regressions, historical (implied) volatility can explain 25% (33%) of the timeseries variation of the CDS spread for ... |

89 |
The model-free implied volatility and its information content.
- Jiang, Tian
- 2005
(Show Context)
Citation Context ...of CDS spreads. Probing deeper into the nature of the information content of option-implied volatility, we focus on the following question: Does implied volatility explain the time-series behavior of CDS spreads because it forecasts future volatility better, or because it captures a volatility risk premium? For the first part of this question, the extant literature has examined the power of implied volatility to predict future realized volatility, producing generally mixed evidence (Day and Lewis, 1992; Canina and Figlewski, 1993; Lamoureux and Lastrapes, 1993; Christensen and Prabhala, 1998; Jiang and Tian, 2005). As for the second part of the question, the difference between implied volatility and the expected future volatility under the objective measure is commonly regarded as a volatility risk premium (Bakshi and Kapadia, 2003; Bates, 2003; Chernov, 2007; Bollerslev et al., 2008, 2009; Zhou, 2009). Because of the similarity between the payoffs of out-of-the-money puts and credit default swaps, this risk premium component can, presumably, help to explain CDS spreads in a way that even the best volatility estimator cannot. To address this important question, we first analyze the predictability of fu... |

82 |
Asymmetric information and options.
- Back
- 1993
(Show Context)
Citation Context ... other hand, short-horizon (e.g., 22-day) historical volatilities may be more attuned to marketmoving news, but they are far too noisy to yield any improvement over the information content of implied volatility. We therefore conclude that the information advantage of implied volatility is robust to historical volatility estimators of different horizons. 5.4. Sub-sample results Because our sample consists of a broad cross-section of firms, we can analyze how the information content of implied volatility for CDS pricing depends on important firm-level characteristics. According to Black (1975), Back (1993), Easley et al. (1998), and others, implied volatility is likely to be informative when the options have sufficient leverage and liquidity, as well as when the amount of information asymmetry in the options market is high. Recent empirical studies, such as Cao et al. (2005) and Pan and Poteshman (2006), have tested these predictions by examining the predictive power of the option volume for future stock returns. ARTICLE IN PRESS C. Cao et al. / Journal of Financial Markets 13 (2010) 321–343 337 Author's personal copy To the extent that options market liquidity is proxied by open interest and t... |

79 |
Dynamic Estimation of Volatility Risk Premia and Investor Risk Aversion from Option-Implied and
- Bollerslev, Gibson, et al.
- 2004
(Show Context)
Citation Context ...captures a volatility risk premium? For the first part of this question, the extant literature has examined the power of implied volatility to predict future realized volatility, producing generally mixed evidence (Day and Lewis, 1992; Canina and Figlewski, 1993; Lamoureux and Lastrapes, 1993; Christensen and Prabhala, 1998; Jiang and Tian, 2005). As for the second part of the question, the difference between implied volatility and the expected future volatility under the objective measure is commonly regarded as a volatility risk premium (Bakshi and Kapadia, 2003; Bates, 2003; Chernov, 2007; Bollerslev et al., 2008, 2009; Zhou, 2009). Because of the similarity between the payoffs of out-of-the-money puts and credit default swaps, this risk premium component can, presumably, help to explain CDS spreads in a way that even the best volatility estimator cannot. To address this important question, we first analyze the predictability of future realized volatility using historical and/or implied volatility. When included alone in the firm-level predictive regressions, historical (implied) volatility can explain 25% (33%) of the timeseries variation of the CDS spread for the average firm in our sample. When bot... |

68 | The information in option volume for future stock prices.
- Pan, Poteshman
- 2006
(Show Context)
Citation Context ...robust to historical volatility estimators of different horizons. 5.4. Sub-sample results Because our sample consists of a broad cross-section of firms, we can analyze how the information content of implied volatility for CDS pricing depends on important firm-level characteristics. According to Black (1975), Back (1993), Easley et al. (1998), and others, implied volatility is likely to be informative when the options have sufficient leverage and liquidity, as well as when the amount of information asymmetry in the options market is high. Recent empirical studies, such as Cao et al. (2005) and Pan and Poteshman (2006), have tested these predictions by examining the predictive power of the option volume for future stock returns. ARTICLE IN PRESS C. Cao et al. / Journal of Financial Markets 13 (2010) 321–343 337 Author's personal copy To the extent that options market liquidity is proxied by open interest and trading volume, and the degree of information asymmetry increases with the volatility of the CDS spread and decreases with credit rating, we create sub-samples by sorting on these firmlevel characteristics and summarize the regression results for each sub-sample. Indeed, results not presented here confi... |

66 | Decomposing Swap Spreads - Feldhütter, Lando - 2008 |

62 | Informational content of option volume prior to takeovers.
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- 2005
(Show Context)
Citation Context ...implied volatility is robust to historical volatility estimators of different horizons. 5.4. Sub-sample results Because our sample consists of a broad cross-section of firms, we can analyze how the information content of implied volatility for CDS pricing depends on important firm-level characteristics. According to Black (1975), Back (1993), Easley et al. (1998), and others, implied volatility is likely to be informative when the options have sufficient leverage and liquidity, as well as when the amount of information asymmetry in the options market is high. Recent empirical studies, such as Cao et al. (2005) and Pan and Poteshman (2006), have tested these predictions by examining the predictive power of the option volume for future stock returns. ARTICLE IN PRESS C. Cao et al. / Journal of Financial Markets 13 (2010) 321–343 337 Author's personal copy To the extent that options market liquidity is proxied by open interest and trading volume, and the degree of information asymmetry increases with the volatility of the CDS spread and decreases with credit rating, we create sub-samples by sorting on these firmlevel characteristics and summarize the regression results for each sub-sample. Indeed, res... |

58 | Stock options and credit default swaps: A joint framework for valuation and estimation. - Carr, Wu - 2010 |

51 | Modeling credit risk with partial information, Working paper, Cornell University, forthcoming, Annals of Applied Probability. - Cetin, Jarrow, et al. - 2003 |

46 | Inferring Future Volatility from the Information in Implied Volatility in Eurodollar Options: A New Approach, - Amin, Ng - 1997 |

43 | Explaining Credit Default Swap Spreads with the Equity Volatility and Jump Risks of Individual Firms.
- Zhang, Zhou, et al.
- 2009
(Show Context)
Citation Context ... prior to the expiration of the contract. Fueled by the eagerness of banks, insurance companies, and hedge funds to take on or shed credit risk exposures, the CDS market has been growing exponentially during the past decade, reaching $62 trillion in notional amount outstanding by the end of 2007.1 This dramatic development obviates the need for a better understanding of the valuation of credit risk. In response, a recent strand of literature has recognized the important role of firmlevel volatility in the determination of CDS spreads (e.g., Collin-Dufresne et al., 2001; Ericsson et al., 2009; Zhang et al., 2009). Considering that credit default swaps share similar payoff characteristics with certain types of options (e.g., out-of-the-money puts) in that both offer a low cost and effective protection against downside risk, we conduct a comprehensive analysis of the relation between CDS spreads and option-implied volatilities.2 The rationale for relying ARTICLE IN PRESS Sp re ad AT&T Fig. 1. AT&T CDS spreads. This figure plots the time-series of CDS spreads of AT&T Corp. from January 2001 to June 2005 before it was acquired by SBC. CDS Spread is the market CDS spread provided by Markit Group. Model Spr... |

40 | Mertons Model, Credit Risk and Volatility Skews,” working paper, - Hull, Nelken, et al. - 2004 |

34 | The credit-default swap market: Is credit protection priced correctly? Working paper, Anderson School at UCLA, NBER Working Paper Series - Longstaff, Mithal, et al. - 2003 |

31 | Can structural models price default risk? Evidence from bond and credit derivative markets, Working paper, - Ericsson, Reneby, et al. - 2005 |

26 | Are jumps in corporate bond yields priced? Modeling contagion via the updating of beliefs, - Collin-Dufresne, Goldstein, et al. - 2003 |

25 |
Volatility risk premium embedded in individual equity options: Some new insights.
- Bakshi, Kapadia
- 2003
(Show Context)
Citation Context ... it forecasts future volatility better, or because it captures a volatility risk premium? For the first part of this question, the extant literature has examined the power of implied volatility to predict future realized volatility, producing generally mixed evidence (Day and Lewis, 1992; Canina and Figlewski, 1993; Lamoureux and Lastrapes, 1993; Christensen and Prabhala, 1998; Jiang and Tian, 2005). As for the second part of the question, the difference between implied volatility and the expected future volatility under the objective measure is commonly regarded as a volatility risk premium (Bakshi and Kapadia, 2003; Bates, 2003; Chernov, 2007; Bollerslev et al., 2008, 2009; Zhou, 2009). Because of the similarity between the payoffs of out-of-the-money puts and credit default swaps, this risk premium component can, presumably, help to explain CDS spreads in a way that even the best volatility estimator cannot. To address this important question, we first analyze the predictability of future realized volatility using historical and/or implied volatility. When included alone in the firm-level predictive regressions, historical (implied) volatility can explain 25% (33%) of the timeseries variation of the CD... |

25 | Explaining Credit Default Swap Premia. - Benkert - 2004 |

23 |
On the role of risk premia in volatility forecasting,
- Chernov
- 2007
(Show Context)
Citation Context ... or because it captures a volatility risk premium? For the first part of this question, the extant literature has examined the power of implied volatility to predict future realized volatility, producing generally mixed evidence (Day and Lewis, 1992; Canina and Figlewski, 1993; Lamoureux and Lastrapes, 1993; Christensen and Prabhala, 1998; Jiang and Tian, 2005). As for the second part of the question, the difference between implied volatility and the expected future volatility under the objective measure is commonly regarded as a volatility risk premium (Bakshi and Kapadia, 2003; Bates, 2003; Chernov, 2007; Bollerslev et al., 2008, 2009; Zhou, 2009). Because of the similarity between the payoffs of out-of-the-money puts and credit default swaps, this risk premium component can, presumably, help to explain CDS spreads in a way that even the best volatility estimator cannot. To address this important question, we first analyze the predictability of future realized volatility using historical and/or implied volatility. When included alone in the firm-level predictive regressions, historical (implied) volatility can explain 25% (33%) of the timeseries variation of the CDS spread for the average fir... |

22 | Measuring treasury market liquidity
- Fleming
- 2003
(Show Context)
Citation Context ...read contains both liquidity risk and credit risk components, as well as a swap-specific component related to hedging activities in the mortgage-backed securities market. However, they show that the liquidity component is by far the largest and most variable part of the swapTreasury spread. Of course, using the swap-Treasury spread itself spares us from estimation errors, because we are not filtering the data through any particular model. The second model-independent measure we use is the difference between 10-year on-the-run and first off-the-run Treasury yields, following the methodology of Fleming (2003), which has been used by numerous other studies (see Fleming, 2003, for additional references).9 Table 7 presents estimation results using each of the three credit market illiquidity measures. While our original illiquidity measure is positive and significant, the coefficient of the swap-Treasury spread (and the coefficient of the difference between on-the-run and ARTICLE IN PRESS Table 7 The impact of alternative credit market illiquidity measures. Cross-sectional averages of coefficients, t-statistics (in parentheses), and adjusted R-squares of time-series regressions for 301 sample firms wi... |

12 | Liquidity and credit risk, working paper, - Ericsson, Renault - 2002 |

10 |
Individual stock option prices and credit spreads. Working paper,
- Cremers, Driessen, et al.
- 2008
(Show Context)
Citation Context ...to explain CDS spreads stems from a combination of better prediction of future volatility and the volatility risk premium embedded in option prices. Our paper contributes to the extant literature in a number of ways. Campbell and Taksler (2003), Ericsson et al. (2009) and Zhang et al. (2009) have demonstrated a strong relation between credit spreads and equity historical volatilities. We focus instead on the relation between CDS spreads and options market information and show that option-implied volatility is an even more important determinant of CDS spreads than equity historical volatility. Cremers et al. (2008) estimate the relation between corporate bond yield spreads and options market variables. They adopt a panel regression approach, which relies on information from the cross-section of firms for identification. Motivated by the AT&T illustration (Fig. 1), we are more concerned about the time-series relation between the two markets for each individual firm; therefore, we estimate the relation between credit spreads and implied volatility using firm-level time-series regressions. By combining firm-level CDS and options data, our paper advances the early literature on the information content of im... |

9 | Insider trading in credit derivatives, Working paper, - Acharya, Johnson - 2005 |

8 | Variance risk premia, asset predictability puzzles, and macroeconomic uncertainty. Working paper, Federal Reserve Board.
- Zhou
- 2009
(Show Context)
Citation Context ...ium? For the first part of this question, the extant literature has examined the power of implied volatility to predict future realized volatility, producing generally mixed evidence (Day and Lewis, 1992; Canina and Figlewski, 1993; Lamoureux and Lastrapes, 1993; Christensen and Prabhala, 1998; Jiang and Tian, 2005). As for the second part of the question, the difference between implied volatility and the expected future volatility under the objective measure is commonly regarded as a volatility risk premium (Bakshi and Kapadia, 2003; Bates, 2003; Chernov, 2007; Bollerslev et al., 2008, 2009; Zhou, 2009). Because of the similarity between the payoffs of out-of-the-money puts and credit default swaps, this risk premium component can, presumably, help to explain CDS spreads in a way that even the best volatility estimator cannot. To address this important question, we first analyze the predictability of future realized volatility using historical and/or implied volatility. When included alone in the firm-level predictive regressions, historical (implied) volatility can explain 25% (33%) of the timeseries variation of the CDS spread for the average firm in our sample. When both are included in t... |

7 | How proÞtable is capital structure arbitrage? Working paper, - Yu - 2005 |

4 |
Do Equity Markets Favor Credit Market News over Options Market News? Working Paper,
- Berndt, Ostrovnaya
- 2007
(Show Context)
Citation Context ... (H0: b2 b1 vs. H1: b24b1) 59% 47% 41% 37% 40% Percentage of tr1:64 (H0: b2 b1 vs. H1: b2ob1) 9% 18% 26% 29% 31% C. Cao et al. / Journal of Financial Markets 13 (2010) 321–343338 Author's personal copy CDS pricing is greater among firms with lower credit ratings, higher CDS spread volatilities, and more actively traded options. These results are available upon request. 5.5. Lead-lag relation between options and CDS markets So far, we have focused on the contemporaneous relation between the CDS spread and firm-level volatility measures. The recent studies of Acharya and Johnson (2007) and Berndt and Ostrovnaya (2008) analyze the lead-lag relation among stock, CDS, and options markets around abrupt changes in CDS spreads or corporate news announcements. Using their methodology, we examine the unconditional flow of information between the options market and the CDS market, which can shed further light on the information content of implied volatility for CDS valuation. Our results (available upon request) identify a robust predictability of future CDS spread changes from current implied volatility innovations. Interestingly, the predictability in the opposite direction appears much weaker. Overall, our resul... |

3 | Valuing corporate liabilities, Working paper, - Ericsson, Reneby - 2003 |

3 | Corporate yield spreads: Defalt risk or liquidity? New evidence from the credit-default swap market, Working paper, UCLA, forthcoming in the Journal of Finance. - Longstaff, Mithal, et al. - 2004 |

2 | Do credit spreads reßect stationary leverage ratios? - Collin-Dufresne, Goldstein - 2001 |

2 | And now for capital structure arbitrage, - Currie, Morris - 2002 |

2 | Risk and return in Þxed income arbitrage: Nickels in front of a steamroller? Working paper, - Duarte, Longstaff, et al. - 2005 |

1 | 321–343342 Author's personal copy - Cao - 2010 |

1 | Credit risk changes: Common factors and Þrm-level fundamentals, Working paper, - Avramov, Jostova, et al. - 2004 |