Ebook Credit Default Swap Spreads and Variance Risk Premia
Variance risk premium can be defined as the difference between model-free option implied variance and the expected variance based on realized measures estimated from high-frequency data (see Britten-Jones and Beuberger, 2000; Jiang and Tian, 2005; Carr and Wu, 2008b, among others). Variance risk premium arises as investors demand compensation for the risk associated with uncertain fluctuation in the fundamental’s volatility process (Bollerslev, Tauchen, and Zhou, 2009; Drechsler and Yaron, 2009). On the macro level, variance risk premium has been shown to capture the macroeconomic uncertainty risk embedded in stock returns, as well as bond returns and credit spreads (Zhou, 2009). In this paper, we construct individual firms’ variance risk premiums and conduct a comprehensive study on the empirical relationship between the cross sections of firms’ credit spreads and variance risk premia.
We find that firm-level variance risk premium is the most significant predictor for the credit spread variation, relative to other macroeconomic and firm specific credit risk determinants identified in the existing literature. Variance risk premium complements leverage ratio that has been shown as the leading explanatory variable for credit spreads (Collin Dufresne and Goldstein, 2001). Interestingly, firm-level variance risk premium crowds out its market-level counterpart, and the latter is a strong predictor for aggregate credit spread indices (Zhou, 2009). Such a predictive power turns out to be stronger for credit spreads of the speculative grade and longer contract maturity. The model-free variance risk premium performs better than those constructed from either call or put options with different moneyness. Variance risk premium contains a larger systematic component than implied and expected variances. Our empirical findings have some implications for credit risk modeling.
It has been long recognized in literature that a critical component of systematic risk may be missing in the credit risk modeling (Jones, Mason, and Rosenfeld, 1984; Elton, Gruber, Agrawal, and Mann, 2001; Collin-Dufresne, Goldstein, and Martin, 2001; Huang and Huang, 2003), leading to the so-called credit spread puzzle. As evidenced by the recent credit crisis, the relatively large spike of the high investment-grade credits signifies a systematic shock that has very little to do with the actual individual default frequency of these securities. Our findings provide a microeconomic support that variance risk premium may capture a firm asset’s exposure to such a macroeconomic uncertainty risk. The finding here is consistent with recent research that recognizes the linkage among macroeconomic condition, equity risk premium, and credit risk pricing (see, e.g., David, 2008; Bhamra, Kuhn, and Strebulaev, 2009; Chen, Collin-Dufresne, and Goldstein, 2009; Chen, 2009), but with a focus on providing the cross-sectional evidence of individual firms.
Previous research presents overwhelming evidence that implied variance is always informationally more efficient than realized variance in predicting credit spreads (Cao, Yu, and Zhong, 2008; Berndt, Lookman, and Obreja, 2006; Carr and Wu, 2008a; Buraschi, Trojani, and Vedolin, 2009). However, it remains unclear to what extent the predictability comes from better informational efficiency of option market, from risk premium changes, or from expected variance changes. By decomposing the option-implied variance, we provide a convincing economic interpretation as to where the predictability exactly comes from. We find that variance risk premium can substitute most of the explaining power of the implied variance. Nevertheless, variance risk premium and expected variance are two indispensable components in terms of predicting credit spreads, suggesting that there may exist a two factor structure of the firm’s variance risk dynamics behind its superior explaining power.
To understand why variance risk premium may be an ideal measure of firms’ exposures to systematic variance or economic uncertainty risk, we note that the risk-neutral expectation and physical expectation of the total variance only differ for priced systematic component, but remain the same for non-priced idiosyncratic component. As supported the empirical evidence, the first principle component of variance risk premium across all firms explains 78% of the total variation, while that of implied variance only explains 54% and expected variance only 57%. Therefore the economic interpretation of implied variance in explaining credit spread largely resides on variance risk premia that are exposed to the macroeconomic uncertainty risk, while the informational efficiency of implied variance may be mostly attributed to the comovements between the credit and option markets that are largely idiosyncratic in nature.
Download
PDF Ebook Credit Default Swap Spreads and Variance Risk Premia
Posted in :
