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, pseudo bonds are equivalent to Treasuries minus put options on pseudo firm assets. Empirically, like corporate spreads, pseud...

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Bibliographic Details
Published in:	The American economic review Vol. 108; no. 2; pp. 454 - 488
Main Authors:	Culp, Christopher L., Nozawa, Yoshio, Veronesi, Pietro
Format:	Journal Article
Language:	English
Published:	Nashville American Economic Association 01-02-2018
Subjects:	Assets Bond issues Bond markets Credit risk Economic growth International finance Put & call options Spread Zero coupon bonds
Online Access:	Get full text
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Summary:	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’ overestimation 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.
ISSN:	0002-8282 1944-7981
DOI:	10.1257/aer.20151606