Skip to main content

We use cookies to distinguish you from other users and to provide you with a better experience on our websites. Close this message to accept cookies or find out how to manage your cookie settings.

Close cookie message
Cancel
×
×
Home
  • Home
Article
  • Cited by 2
  • Cited by
    Crossref Citations
    Crossref logo
    This article has been cited by the following publications. This list is generated based on data provided by CrossRef.
    Tang, Dragon Yongjun and Yan, Hong 2017. Understanding transactions prices in the credit default swaps market. Journal of Financial Markets, Vol. 32, Issue. , p. 1.
    Carr, Peter and Wu, Liuren 2017. Leverage Effect, Volatility Feedback, and Self-Exciting Market Disruptions. Journal of Financial and Quantitative Analysis, Vol. 52, Issue. 05, p. 2119.
    ×
  • Get access
    Add to cart USD25.00
    Check if you have access via personal or institutional login
    Log in Register Recommend to librarian

Anchoring Credit Default Swap Spreads to Firm Fundamentals

  • Jennie Bai and Liuren Wu
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 R 2 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.

Copyright
COPYRIGHT: © Michael G. Foster School of Business, University of Washington 2016 
Corresponding author
* Bai, jennie.bai@georgetown.edu, McDonough School of Business, Georgetown University; Wu (corresponding author), liuren.wu@baruch.cuny.edu, Zicklin School of Business, Baruch College.
References
Hide All
Altman, E. I.“Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy.” Journal of Finance, 23 (1968), 589–609.
Altman, E. I.“Measuring Corporate Bond Mortality and Performance.” Journal of Finance, 44 (1989), 909–922.
Andrews, D. W. K.“Heteroskedasticity and Autocorrelation Consistent Covariance Matrix Estimation.” Econometrica, 59 (1991), 817–858.
Avramov, D.; Jostova, G.; and Philopov, A.. “Understanding Changes in Corporate Credit Spreads.” Financial Analysts Journal, 63 (2007), 90–105.
Bao, J., and Pan, J.. “Bond Illiquidity and Excess Volatility.” Review of Financial Studies, 26 (2013), 3068–3103.
Berndt, A., and Ostrovnaya, A.. “Do Equity Markets Favor Credit Market News over Options Market News?” Quarterly Journal of Finance, 4 (2014), 1450006.
Bharath, S. T., and Shumway, T.. “Forecasting Default with the Merton Distance to Default Model.” Review of Financial Studies, 21 (2008), 1339–1369.
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), 2255–2281.
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), 203–240.
Campbell, J. Y., and Taksler, G. B.. “Equity Volatility and Corporate Bond Yields.” Journal of Finance, 63 (2003), 2321–2349.
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), 321–343.
Carr, P., and Wu, L.. “Stock Options and Credit Default Swaps: A Joint Framework for Valuation and Estimation.” Journal of Financial Econometrics, 8 (2010), 409–449.
Carr, P., and Wu, L.. “A Simple Robust Link between American Puts and Credit Protection.” Review of Financial Studies, 24 (2011), 473–505.
Chen, L.; Lesmond, D. A.; and Wei, J.. “Corporate Yield Spreads and Bond Liquidity.” Journal of Finance, 62 (2007), 119–149.
Collin-Dufresne, P.; Goldstein, R. S.; and Martin, J. S.. “The Determinants of Credit Spread Changes.” Journal of Finance, 56 (2001), 2177–2207.
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), 2209–2242.
Cremers, M.; Driessen, J.; Maenhout, P. J.; and Weinbaum, D.. “Individual Stock Options and Credit Spreads.” Journal of Banking and Finance, 32 (2008), 2706–2715.
Crosbie, P., and Bohn, J.. “Modeling Default Risk.” Working Paper, Moodys KMV (2003).
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), 212–228.
Duan, J.-C.; Sun, J.; and Wang, T.. “Multiperiod Corporate Default Prediction—A Forward Intensity Approach.” Journal of Econometrics, 170 (2012), 191–209.
Duan, J.-C., and Wang, T.. “Measuring Distance-to-Default for Financial and Non-Financial Firms.” Global Credit Review, 2 (2012), 95–108.
Duffie, D.; Saita, L.; and Wang, K.. “Multi-Period Corporate Default Prediction with Stochastic Covariates.” Journal of Financial Economics, 83 (2007), 635–665.
Eom, Y. H.; Helwege, J.; and Huang, J.-Z.. “Structural Models of Corporate Bond Pricing: An Empirical Analysis.” Review of Financial Studies, 17 (2004), 499–544.
Ericsson, J.; Jacobs, K.; and Oviedo, R.. “The Determinants of Credit Default Swap Premia.” Journal of Financial and Quantitative Analysis, 44 (2009), 109–132.
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).
Fama, E. F., and French, K. R.. “Common Risk Factors in the Returns on Stocks and Bonds.” Journal of Financial Economics, 33 (1993), 3–56.
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), 153–202.
Jegadeesh, N., and Titman, S.. “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency.” Journal of Finance, 48 (1993), 65–91.
Jegadeesh, N., and Titman, S.. “Profitability of Momentum Strategies: An Evaluation of Alternative Explanations.” Journal of Finance, 56 (2001), 699–720.
Kealhofer, S.“Quantifying Credit Risk I: Default Prediction.” Financial Analysts Journal, 59 (2003), 30–44.
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), 1575–1608.
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), 2213–2253.
Merton, R. C.“On the Pricing of Corporate Debt: The Risk Structure of Interest Rates.” Journal of Finance, 29 (1974), 449–470.
Newey, W. K., and West, K. D.. “A Simple, Positive Semi-Definite, Heteroskedasticity and Autocorrelation Consistent Covariance Matrix.” Econometrica, 55 (1987), 703–708.
Wang, H.; Zhou, H.; and Zhou, Y.. “Credit Default Swap Spreads and Variance Risk Premia.” Journal of Banking and Finance, 37 (2013), 3733–3746.
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), 5099–5131.
Recommend this journal

Email your librarian or administrator to recommend adding this journal to your organisation's collection.

Journal of Financial and Quantitative Analysis
  • ISSN: 0022-1090
  • EISSN: 1756-6916
  • URL: /core/journals/journal-of-financial-and-quantitative-analysis
Please enter your name
Please enter a valid email address
Who would you like to send this to? *

CAPTCHA *

Skip to the audio challenge
×
Type Description Title
UNKNOWN
Supplementary materials

Bai and Wu supplementary material
Appendix

 Unknown (116 KB)
116 KB

Metrics

Full text views

Total number of HTML views: 1
Total number of PDF views: 286 *
Loading metrics...

Abstract views

Total abstract views: 712 *
Loading metrics...

* Views captured on Cambridge Core between 16th December 2016 - 12th June 2018. This data will be updated every 24 hours.

Cancel
Confirm
×