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RFS Advance Access published online on August 19, 2008
Review of Financial Studies, doi:10.1093/rfs/hhn071
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© The Author 2008. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org

Explaining the Level of Credit Spreads: Option-Implied Jump Risk Premia in a Firm Value Model

K.J. Martijn Cremers
Yale School of Management, International Center for Finance

Joost Driessen
University of Amsterdam Business School

Pascal Maenhout
Finance Department, INSEAD

Address correspondence to Joost Driessen, University of Amsterdam Business School, Roetersstraat 11, 1018 WB Amsterdam, the Netherlands and Netspar, telephone: +31-20-5255263; e-mail: J.J.A.G.Driessen{at}uva.nl.

JEL Classification: G12, G13


  Abstract

We study whether option-implied jump risk premia can explain the high observed level of credit spreads. We use a structural jump-diffusion firm value model to assess the level of credit spreads generated by option-implied jump risk premia. Prices and returns of equity index and individual options are used to estimate the jump parameters. We further calibrate the model to historical information on default risk and the equity premium. The results show that incorporating option-implied jump risk premia brings predicted credit spread levels much closer to observed levels. The introduction of jumps also helps to improve the fit of the volatility of credit spreads and equity returns.

We thank Bernard Dumas, Frank de Jong, Hayne Leland, Liuren Wu, seminar participants at HEC Lausanne, the BIS workshop "Pricing of Credit Risk" (in particular, the discussants Varqa Khadem and Garry Young), the 2006 EFA Meetings in Zurich, the 2006 Venice Conference on Credit Risk, and the Netspar Pension Day at Tilburg University for helpful comments and suggestions. We are very grateful for the comments and suggestions of the Editor (Yacine Aït-Sahalia) and of two anonymous referees.


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