Explaining Credit Default Swap Spreads With the Equity Volatility and Jump Risks of Individual Firms

This paper attempts to explain the credit default swap (CDS) premium, using a novel approach to identify the volatility and jump risks of individual firms from high-frequency equity prices. Our empirical results suggest that the volatility risk alone predicts 48 percent of the variation in CDS spread levels, whereas the jump risk alone forecasts 19 percent. After controlling for credit ratings, macroeconomic conditions, and firms' balance sheet information, we can explain 73 percent of the total variation. We calibrate a Merton-type structural model with stochastic volatility and jumps, which can help to match credit spreads after controlling for the historical default rates. Simulation evidence suggests that the high-frequency-based volatility measures can help to explain the credit spreads, above and beyond what is already captured by the true leverage ratio.

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