Option-Based Credit Spreads

NBER Working Paper No. 20776

Issued in December 2014, Revised in September 2017

NBER Program(s):Asset Pricing, Corporate Finance



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, pseudo 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, and corporate frictions 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.

Acknowledgments

Machine-readable bibliographic record - MARC, RIS, BibTeX

Document Object Identifier (DOI): 10.3386/w20776

Published: Christopher L. Culp & Yoshio Nozawa & Pietro Veronesi, 2018. "Option-Based Credit Spreads," American Economic Review, vol 108(2), pages 454-488.

Users who downloaded this paper also downloaded* these: