Option-Based Credit Spreads

Pietro Veronesi, Yoshio Nozawa and Christopher L. Culp

No 10318, CEPR Discussion Papers from Centre for Economic Policy Research

Abstract: We present a novel empirical benchmark for analyzing credit risk using "pseudo firms" that purchase traded assets financed with equity and zero-coupon bonds. By no-arbitrage, the bonds are equivalent to Treasuries minus put options on pseudo-firm assets. Empirically, like corporate spreads, pseudo-bond spreads are large, countercyclical, and predict lower economic growth. Using this framework, we find that bond market illiquidity, investors? over-estimation of default risks, corporate frictions, and constraints on aggregate credit supply do not seem to explain excessive observed credit spreads, but, instead, a risk premium for tail and idiosyncratic asset risks is the primary determinant of corporate spreads.

Keywords: Credit spreads; Default; Merton model; Options (search for similar items in EconPapers)
JEL-codes: G1 G12 G13 G21 G24 G3 (search for similar items in EconPapers)
Date: 2014-12
New Economics Papers: this item is included in nep-ban and nep-rmg
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Citations: View citations in EconPapers (4)

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