The information content of CDS implied volatility and associated trading strategies

Yukun Shi, Ding Chen, Biao Guo, Yaofei Xu and Cheng Yan

International Review of Financial Analysis, 2022, vol. 83, issue C

Abstract: Using the theoretical link between put options and credit default swaps (CDS) in a very general setting, we develop a robust measure of CDS implied volatility (CIV) that captures the information content of CDS markets. Specifically, we use the unit recovery claim to bridge CDS and deep out-of-the-money put options of the same firm and then back out CIV via the binomial tree. Our CIV measure strongly co-moves with the option implied volatility (OIV), with a correlation coefficient of 0.8. Based on the standardized difference between CIV and OIV, we construct CDS and option trading strategies. Without taking transaction costs into account, the long–short CDS trading strategy achieves an annualized return of 58.29% and a Sharpe ratio of 2.97, which cannot be explained by non-parametric skewness and volatility risk.

Keywords: CDS; Implied volatility; Default probability; Unit recovery claim; Trading strategies (search for similar items in EconPapers)
JEL-codes: C13 C51 G11 G12 (search for similar items in EconPapers)
Date: 2022
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Persistent link: https://EconPapers.repec.org/RePEc:eee:finana:v:83:y:2022:i:c:s1057521922002502

DOI: 10.1016/j.irfa.2022.102295

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