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Option-Based Credit Spreads

Christopher L. Culp, Yoshio Nozawa and Pietro Veronesi

No 20776, NBER Working Papers from National Bureau of Economic Research, Inc

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, pseudo 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, and corporate frictions 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.

JEL-codes: G0 G12 G13 G21 G24 G3 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ban and nep-cfn
Date: 2014-12
Note: AP CF
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Published as Christopher L. Culp & Yoshio Nozawa & Pietro Veronesi, 2018. "Option-Based Credit Spreads," American Economic Review, vol 108(2), pages 454-488.

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