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Credit default swap spreads and variance risk premia

Hao Wang, Hao Zhou and Yi Zhou

Journal of Banking & Finance, 2013, vol. 37, issue 10, 3733-3746

Abstract: We find that the firm-level variance risk premium has a prominent explanatory power for credit spreads in the presence of market- and firm-level control variables established in the existing literature. Such predictability complements that of the leading state variable—the leverage ratio—and strengthens significantly with a lower firm credit rating, longer credit contract maturity, and model-free implied variance. We provide further evidence that (1) the variance risk premium has a cleaner systematic component than implied variance or expected variance, (2) the cross-section of firms’ variance risk premia capture systematic variance risk in a stronger way than firms’ equity returns in capturing market return risk, and (3) a structural model with stochastic volatility can reproduce the predictability pattern of variance risk premia for credit spreads.

Keywords: Variance risk premia; Credit default swap spreads; Option-implied variance; Expected variance; Realized variance (search for similar items in EconPapers)
JEL-codes: G12 G13 G14 (search for similar items in EconPapers)
Date: 2013
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