Explaining credit default swap spreads with equity volatility and jump risks of individual firms

Zhu Haibin, Benjamin Zhang and Hao Zhou
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Benjamin Zhang: Fitch Ratings Inc.

No 181, BIS Working Papers from Bank for International Settlements

Abstract: A structural model with stochastic volatility and jumps implies particular relationships between observed equity returns and credit spreads. This paper explores such effects in the credit default swap (CDS) market. We use a novel approach to identify the realized jumps of individual equity from high frequency data. Our empirical results suggest that volatility risk alone predicts 50% of CDS spread variation, while jump risk alone forecasts 19%. After controlling for credit ratings, macroeconomic conditions, and firms' balance sheet information, we can explain 77% of the total variation. Moreover, the marginal impacts of volatility and jump measures increase dramatically from investment grade to high-yield entities. The estimated nonlinear effects of volatility and jumps are in line with the model implied relationships between equity returns and credit spreads.

Keywords: structural model; stochastic volatility; jumps; credit spread; credit default swap; nonlinear effect; high frequency data (search for similar items in EconPapers)
JEL-codes: C14 G12 G13 (search for similar items in EconPapers)
Pages: 45 pages
Date: 2005-09
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Citations: View citations in EconPapers (36)

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Related works:
Journal Article: Explaining Credit Default Swap Spreads with the Equity Volatility and Jump Risks of Individual Firms (2009)
Working Paper: Explaining credit default swap spreads with the equity volatility and jump risks of individual firms (2005)
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