Discussion Paper Details

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Title: Option-Based Credit Spreads

Author(s): Christopher L. Culp, Yoshio Nozawa and Pietro Veronesi

Publication Date: December 2014

Keyword(s): credit spreads, default, Merton model and options

Programme Area(s): Financial Economics

Abstract: We present a novel empirical benchmark for analyzing credit risk using "pseudo firms" that purchase traded assets financed with equity and zero-coupon bonds. By no-arbitrage, the bonds are equivalent to Treasuries minus put options on pseudo-firm assets. Empirically, like corporate spreads, pseudo-bond spreads are large, countercyclical, and predict lower economic growth. Using this framework, we find that bond market illiquidity, investors? over-estimation of default risks, corporate frictions, and constraints on aggregate credit supply do not seem to explain excessive observed credit spreads, but, instead, a risk premium for tail and idiosyncratic asset risks is the primary determinant of corporate spreads.

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Bibliographic Reference

Culp, C, Nozawa, Y and Veronesi, P. 2014. 'Option-Based Credit Spreads'. London, Centre for Economic Policy Research.