Hostname: page-component-78c5997874-v9fdk Total loading time: 0 Render date: 2024-11-05T21:30:37.844Z Has data issue: false hasContentIssue false

Anchoring Credit Default Swap Spreads to Firm Fundamentals

Published online by Cambridge University Press:  16 December 2016

Abstract

In this article, we examine the extent to which firm fundamentals can explain the cross-sectional variation in credit default swap (CDS) spreads. We construct a fundamental CDS valuation by combining the Merton distance-to-default measure with a long list of firm fundamentals via a Bayesian shrinkage method. Regressing CDS quotes against the fundamental valuation cross-sectionally generates an average R2 of 77%. The explanatory power is stable over time and robust in out-of-sample tests. Deviations between market quotes and the valuation predict future market movements. The results highlight the important role played by firm fundamentals in differentiating the credit spreads of different firms.

Type
Research Article
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2016 

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

References

Altman, E. I.Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy.” Journal of Finance, 23 (1968), 589609.CrossRefGoogle Scholar
Altman, E. I.Measuring Corporate Bond Mortality and Performance.” Journal of Finance, 44 (1989), 909922.CrossRefGoogle Scholar
Andrews, D. W. K.Heteroskedasticity and Autocorrelation Consistent Covariance Matrix Estimation.” Econometrica, 59 (1991), 817858.CrossRefGoogle Scholar
Avramov, D.; Jostova, G.; and Philopov, A.. “Understanding Changes in Corporate Credit Spreads.” Financial Analysts Journal, 63 (2007), 90105.CrossRefGoogle Scholar
Bao, J., and Pan, J.. “Bond Illiquidity and Excess Volatility.” Review of Financial Studies, 26 (2013), 30683103.CrossRefGoogle Scholar
Berndt, A., and Ostrovnaya, A.. “Do Equity Markets Favor Credit Market News over Options Market News?Quarterly Journal of Finance, 4 (2014), 1450006.CrossRefGoogle Scholar
Bharath, S. T., and Shumway, T.. “Forecasting Default with the Merton Distance to Default Model.” Review of Financial Studies, 21 (2008), 13391369.CrossRefGoogle Scholar
Blanco, R.; Brennan, S.; and Marsh, I. W.. “An Empirical Analysis of the Dynamic Relationship between Investment-Grade Bonds and Credit Default Swaps.” Journal of Finance, 60 (2005), 22552281.CrossRefGoogle Scholar
Bongaerts, D.; de Jong, F.; and Driessen, J.. “Derivative Pricing with Liquidity Risk: Theory and Evidence from the Credit Default Swap Market.” Journal of Finance, 66 (2011), 203240.CrossRefGoogle Scholar
Campbell, J. Y., and Taksler, G. B.. “Equity Volatility and Corporate Bond Yields.” Journal of Finance, 63 (2003), 23212349.CrossRefGoogle Scholar
Cao, C.; Yu, F.; and Zhong, Z.. “The Information Content of Option-Implied Volatility for Credit Default Swap Valuation.” Journal of Financial Markets, 13 (2010), 321343.CrossRefGoogle Scholar
Carr, P., and Wu, L.. “Stock Options and Credit Default Swaps: A Joint Framework for Valuation and Estimation.” Journal of Financial Econometrics, 8 (2010), 409449.CrossRefGoogle Scholar
Carr, P., and Wu, L.. “A Simple Robust Link between American Puts and Credit Protection.” Review of Financial Studies, 24 (2011), 473505.CrossRefGoogle Scholar
Chen, L.; Lesmond, D. A.; and Wei, J.. “Corporate Yield Spreads and Bond Liquidity.” Journal of Finance, 62 (2007), 119149.CrossRefGoogle Scholar
Collin-Dufresne, P.; Goldstein, R. S.; and Martin, J. S.. “The Determinants of Credit Spread Changes.” Journal of Finance, 56 (2001), 21772207.CrossRefGoogle Scholar
Cremers, M.; Driessen, J.; and Maenhout, P. J.. “Explaining the Level of Credit Spreads: Option-Implied Jump Risk Premia in a Firm Value Model.” Review of Financial Studies, 21 (2008), 22092242.CrossRefGoogle Scholar
Cremers, M.; Driessen, J.; Maenhout, P. J.; and Weinbaum, D.. “Individual Stock Options and Credit Spreads.” Journal of Banking and Finance, 32 (2008), 27062715.CrossRefGoogle Scholar
Crosbie, P., and Bohn, J.. “Modeling Default Risk.” Working Paper, Moodys KMV (2003).Google Scholar
Du, Y., and Suo, W.. “Assessing Credit Quality from Equity Markets: Can a Structural Approach Forecast Credit Ratings?Canadian Journal of Administrative Sciences, 24 (2007), 212228.CrossRefGoogle Scholar
Duan, J.-C.; Sun, J.; and Wang, T.. “Multiperiod Corporate Default Prediction—A Forward Intensity Approach.” Journal of Econometrics, 170 (2012), 191209.CrossRefGoogle Scholar
Duan, J.-C., and Wang, T.. “Measuring Distance-to-Default for Financial and Non-Financial Firms.” Global Credit Review, 2 (2012), 95108.CrossRefGoogle Scholar
Duffie, D.; Saita, L.; and Wang, K.. “Multi-Period Corporate Default Prediction with Stochastic Covariates.” Journal of Financial Economics, 83 (2007), 635665.CrossRefGoogle Scholar
Eom, Y. H.; Helwege, J.; and Huang, J.-Z.. “Structural Models of Corporate Bond Pricing: An Empirical Analysis.” Review of Financial Studies, 17 (2004), 499544.CrossRefGoogle Scholar
Ericsson, J.; Jacobs, K.; and Oviedo, R.. “The Determinants of Credit Default Swap Premia.” Journal of Financial and Quantitative Analysis, 44 (2009), 109132.CrossRefGoogle Scholar
Ericsson, J.; Reneby, J.; and Wang, H.. “Can Structural Models Price Default Risk? New Evidence from Bond and Credit Derivative Markets.” Working Paper, McGill University, Stockholm School of Economics, and Tsinghua University (2006).CrossRefGoogle Scholar
Fama, E. F., and French, K. R.. “Common Risk Factors in the Returns on Stocks and Bonds.” Journal of Financial Economics, 33 (1993), 356.CrossRefGoogle Scholar
Huang, J.-Z., and Huang, M.. “How Much of the Corporate-Treasury Yield Spread Is Due to Credit Risk?Review of Asset Pricing Studies, 2 (2012), 153202.CrossRefGoogle Scholar
Jegadeesh, N., and Titman, S.. “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency.” Journal of Finance, 48 (1993), 6591.CrossRefGoogle Scholar
Jegadeesh, N., and Titman, S.. “Profitability of Momentum Strategies: An Evaluation of Alternative Explanations.” Journal of Finance, 56 (2001), 699720.CrossRefGoogle Scholar
Kealhofer, S.Quantifying Credit Risk I: Default Prediction.” Financial Analysts Journal, 59 (2003), 3044.CrossRefGoogle Scholar
Lemmon, M. L.; Roberts, M. R.; and Zender, J. F.. “Back to the Beginning: Persistence and the Cross-Section of Corporate Capital Structure.” Journal of Finance, 63 (2008), 15751608.CrossRefGoogle Scholar
Longstaff, F. A.; Mithal, S.; and Neis, E.. “Corporate Yield Spreads: Default Risk or Liquidity? New Evidence from the Credit-Default Swap Market.” Journal of Finance, 60 (2005), 22132253.CrossRefGoogle Scholar
Merton, R. C.On the Pricing of Corporate Debt: The Risk Structure of Interest Rates.” Journal of Finance, 29 (1974), 449470.Google Scholar
Newey, W. K., and West, K. D.. “A Simple, Positive Semi-Definite, Heteroskedasticity and Autocorrelation Consistent Covariance Matrix.” Econometrica, 55 (1987), 703708.CrossRefGoogle Scholar
Wang, H.; Zhou, H.; and Zhou, Y.. “Credit Default Swap Spreads and Variance Risk Premia.” Journal of Banking and Finance, 37 (2013), 37333746.CrossRefGoogle Scholar
Zhang, B. Y.; Zhou, H.; and Zhu, H.. “Explaining Credit Default Swap Spreads with the Equity Volatility and Jump Risks of Individual Firms.” Review of Financial Studies, 22 (2009), 50995131.CrossRefGoogle Scholar
Supplementary material: File

Bai and Wu supplementary material

Appendix

Download Bai and Wu supplementary material(File)
File 115.6 KB