Credit default swaps, the leverage effect, and cross-sectional predictability of equity and firm asset volatility

Santiago Forte and Lidija Lovreta

Journal of Corporate Finance, 2023, vol. 79, issue C

Abstract: Leverage represents both a fundamental component of equity volatility and a long-run selection variable. Based on this premise, we investigate the influence of leverage on the long-run cross-sectional predictability of future realized equity volatility. Leverage makes equity volatility significantly less predictable than underlying firm asset volatility, a result that is robust to different predictors of future realized volatility: credit default swap implied, historical, and option implied volatility. A simple model of optimal capital structure, wherein companies maximize tax benefits subject to a common maximum default probability (minimum credit rating) target, helps explain this finding.

Keywords: Credit default swaps; Capital structure; Asset volatility; Equity volatility; Leverage effect; Cross-sectional predictability (search for similar items in EconPapers)
JEL-codes: G12 G13 G14 G17 G32 G33 (search for similar items in EconPapers)
Date: 2023
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Persistent link: https://EconPapers.repec.org/RePEc:eee:corfin:v:79:y:2023:i:c:s0929119922001900

DOI: 10.1016/j.jcorpfin.2022.102347

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