Option Implied Volatilities and Corporate Bond Yields: A Dynamic Factor Approach

Abstract

This paper estimates dynamic factors from the term structure of credit spreads and the term structure of equity option implied volatilities, and it provides a comprehensive characterization of the dynamic relationships among those credit spread factors and equity volatility factors. The paper finds strong evidence that the volatility factors, especially the volatility level factor, Granger cause credit spread levels, confirming the theoretical predictions of Merton (1974) in a significantly richer and more nuanced environment than previously achieved. Simultaneously, the paper also finds evidence of reverse Granger causality from credit spreads to equity volatility, operating through the slope factors, consistent with the market microstructure literature, which finds that price discovery often happens first in bond markets. Hence the results extend both the corporate bond pricing literatures, deepening our understanding of stock and bond market interaction and suggesting profitable trading strategies.