Explaining the Level of Credit Spreads: Option-implied jump risk premia in a firm value model

by Martijn Cremers of Yale University,
Joost Driessen of the University of Amsterdam,
Pascal Maenhout of INSEAD, and
David Weinbaum of Cornell University

February 2005

Abstract: Prices of equity index put options contain information on the price of systematic downward jump risk. We use a structural jump-diffusion firm value model to assess the level of credit spreads that is generated by option-implied jump risk premia. In our compound option pricing model, an equity index option is an option on a portfolio of call options on the underlying firm values. We calibrate the model parameters to historical information on default risk, the equity premium and equity return distribution, and S&P 500 index option prices. Our results show that a model without jumps fails to fit the equity return distribution and option prices, and generates a low out-of-sample prediction for credit spreads. Adding jumps and jump risk premia improves the fit of the model in terms of equity and option characteristics considerably and brings predicted credit spread levels much closer to observed levels.

JEL Classification: G12, G13.

Keywords: Credit spreads, Firm value model, Jump-diffusion model, Option pricing.

Download paper (346K PDF) 45 pages

[Home] [Credit Pricing Papers]

[ Home ] [ Up ]

Please contact me with problems or suggestions.
Copyright © 2000-2008 DefaultRisk.com
Last modified: May 15, 2008