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.