CDS Spreads Explained with Credit Spread Volatility and Jump Risk of Individual Firms

Abstract

This paper attempts to explain the credit default swap (CDS) premium by using a novel approach to identify the volatility and jump risks of individual firms from a unique dataset of high-frequency CDS spreads. I find that the volatility risk alone explains 55% of the variation in CDS spread levels, whilst the jump risk alone explains 45%. After controlling for credit ratings, macroeconomic conditions and firms’ balance sheet information the model explains 93% of total variation. In the cross-section I find that volatility risk can explain 63% of the variation in the credit spreads whilst jump risk explains 55%. For the CDX index I find that the volatility risk alone explains 22% of the variation in the CDX index levels, while the jump risk alone explains 25%. The results reported in this paper suggest that the time-varying volatility risk premium and jump risk premium of the credit spreads may play a more important role than previously attributed to them.