Discussion paper

DP10318 Option-Based Credit Spreads

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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Citation

Veronesi, P and Y Nozawa (2014), ‘DP10318 Option-Based Credit Spreads‘, CEPR Discussion Paper No. 10318. CEPR Press, Paris & London. https://cepr.org/publications/dp10318