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How Important Is Option-Implied Volatility for Pricing Credit Default Swaps?

Credit default swaps (CDS) are a class of credit derivatives that provide a pay off equal to the loss-given-default on bonds or loans of a reference entity, triggered by credit events such as default, bankruptcy, failure to pay, or restructuring. The buyer pays a premium as a percentage of the notional value of the bonds or loans each quarter, denoted as an annualized spread in basis points (bp), and receives the pay off from the seller should a credit event occur prior to the expiration of the contract.

Fueled by participation from 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 $26 trillion in notional amount outstanding by the first half of 2006. This level has already surpassed the market size for equity and commodity derivatives.

This dramatic development obviates the need for a better understanding of the pricing of credit risk. In response, a recent strand of literature has recognized the important role of fi rm-level volatilities in the determination of bond and CDS spreads. Following this literature, we conduct a comprehensive analysis of the relation between equity volatility and CDS spreads. What sets this study apart from the extant literature is our focus on the economic intuition behind the information content of option-implied volatility for credit default swap valuation.

Consider the choices facing an informed trader who possesses private information regarding the credit risk of an obligor. She could trade on this information in a range of diff erent venues, such as stock, option, bond, and CDS markets. What security she chooses to trade, however, is a function of how sensitive the security prices are with respect to the private information, the relative liquidity of the markets, and the degree of information asymmetry in the markets. This is essentially the conclusion reached in the theoretical model of Easley, O'Hara, and Srinivas (1998). In their \pooling equilibrium" in which the informed trader trades through both the CDS and the option market, there should be a link between the CDS spread and the option-implied volatility (IV ).

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Ebook How Important Is Option-Implied Volatility for Pricing Credit Default Swaps?