Skewed Credit Markets

Abstract

Substantial empirical research has investigated the determinants of credit default swap (CDS) premia. Beside the well-documented impact of implied volatility on spreads only little is known about the informational content of equity option prices to explain the cross-section of CDS spreads. Our study fi lls this gap. A recent strand in the literature finds negative risk premia in CDS spreads for the steepness of the stock option smile. However, this method is unable to distinguish between implied volatility skews and smiles which are frequently encountered in the term structures of single name options. To circumvent this problem our study investigates the dependence between corporate CDS spreads and the skewness of the implied return distribution. Consistent with the predictions of structural credit models we find that skewness has a signi cantly negative impact of on CDS premia. This eff ect is strongest for firms with high implied volatility and volatility risk levels.Furthermore, we investigate the impact of systematic risk factors on the cross section of CDS spreads. Our findings reveal signi ficantly positive impacts of systematic risk and co-skewness risk on single name contracts. They are robust to controlling for market- and firm-level control variables identi fied in the existing literature, as well as to di fferent subperiods such as the 2008/09 subprime crisis.