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Synthetic Options and Implied Volatility for the Corporate Bond Market

Published online by Cambridge University Press:  15 February 2022

Steven Shu-Hsiu Chen
Affiliation:
A. R. Sanchez, Jr. School of Business, Texas A&M International University shu-hsiu.chen@tamiu.edu
Hitesh Doshi
Affiliation:
Bauer College of Business, University of Houston hdoshi@bauer.uh.edu
Sang Byung Seo*
Affiliation:
Wisconsin School of Business, University of Wisconsin–Madison
*
sang.seo@wisc.edu (corresponding author)
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Abstract

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We synthetically create option contracts on a corporate bond index using CDX swaptions, overcoming the limitations that stem from the lack of traded corporate bond options. Our approach allows us to estimate forward-looking moments concerning the corporate bond market in a model-free manner. By constructing an aggregate volatility measure and the associated variance risk premium, we examine the role of volatility risk in the corporate bond market. We highlight that the ex ante conditional second and higher moments we estimate from synthetic corporate bond options carry important implications for credit risk models, providing an extra basis for testing their validity.

Type
Research Article
Creative Commons
Creative Common License - CCCreative Common License - BY
This is an Open Access article, distributed under the terms of the Creative Commons Attribution licence (http://creativecommons.org/licenses/by/4.0), which permits unrestricted re-use, distribution and reproduction, provided the original article is properly cited.
Copyright
© The Author(s), 2022. Published by Cambridge University Press on behalf of the Michael G. Foster School of Business, University of Washington

Footnotes

We thank the anonymous referee and Hendrik Bessembinder (the editor) for their valuable comments and suggestions. We are also grateful to Daniel Andrei, Patrick Augustin, Turan Bali, Daniel Bauer, Fousseni Chabi-Yo, Hui Chen, Ing-Haw Cheng, James Choi, Jesse Davis, Jan Ericsson, Mathieu Fournier, Mohammad Ghaderi, Robert Goldstein, Kris Jacobs, Alexandre Jeanneret, Mete Kilic, Praveen Kumar, Yuguo Liu, Piotr Orlowski, Paola Pederzoli, Erwan Quintin, Mark Ready, Ivan Shaliastovich, Viktor Todorov, Aurelio Vasquez, and seminar participants at the 2020 Western Finance Association meeting, 2019 HEC-McGill Winter Finance Workshop, Bank of Italy, University of Houston, and University of Wisconsin–Madison for helpful comments. An earlier version of this article was circulated under the titles “Corporate Bond VIX” and “Ex Ante Risk in the Corporate Bond Market: Evidence from Synthetic Options.”

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