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| The Information Content of Option-Implied Volatility for Credit Default Swap Valuation by Charles Cao of Pennsylvania State University, May 6, 2009 Abstract: This study investigates whether option-implied volatility is an important determinant of credit default swap (CDS) spreads. Using a large sample of firms with CDS data available, we find that individual firm' put option-implied volatility alone explains 46 percent of the variation in CDS spreads during 2001-06 and 56 percent during a more volatile subperiod of 2001-04. The contemporaneous link between the CDS market and the options market is stronger among firms with lower credit ratings, higher CDS spread volatilities, and more liquid options. Moreover, changes in implied volatilities have strong predictive power for future changes in CDS spreads. We interpret these ?findings as broadly consistent with a unique role for options market information in the process of price discovery across the options and credit markets. The explanatory power of implied volatility for CDS spreads is partly attributed to the volatility risk premium embedded in option prices. Download paper (352K PDF) 51 pages
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