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Credit default swap spreads and variance risk premia
Authors:Hao Wang  Hao Zhou  Yi Zhou
Institution:1. Tsinghua University, School of Economics and Management, 318 Weilun Building, Beijing 100084, China;2. Tsinghua University, PBC School of Finance, 43 Chengfu Road, Haidian District, Beijing 100083, China;3. Florida State University, Department of Finance, College of Business, Rovetta Business Bldg, 353, 821 Academic Way, P.O. Box 3061110, Tallahassee, FL 32306-1110, USA
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:G12  G13  G14
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