Zhaodong Zhong

Pricing Credit Default Swaps with Option-Implied Volatility

Using the industry benchmark CreditGrades model to analyze credit default swap (CDS) spreads across a large number of companies during the 2007–09 credit crisis, the authors demonstrate that the performance of the model can be significantly improved by calibrating it with option-implied volatility rather than with historical volatility. Moreover, the advantage of using option-implied volatility is greater among companies with more volatile CDS spreads, more actively traded options, and lower credit ratings. Structural credit risk models are important tools in relative value trading strategies because they use equity market information to price such credit-risky securities as corporate bonds and credit default swaps (CDSs). One of the most important inputs for such models is equity volatility, which can be estimated from either historical returns or equity option prices. We examined the relative performance of historical versus option-implied volatility in CDS pricing through the lens of an industry benchmark model called CreditGrades, which was jointly developed by the RiskMetrics Group, J.P. Morgan, Goldman Sachs, and Deutsche Bank in 2002. Using CDS and options market data on 332 companies over January 2007–October 2009 (which encompasses the recent credit crisis), we found that option-implied volatility generally dominates historical volatility in both in-sample and out-of-sample pricing performance. This finding is robust to the horizon of the historical volatility estimator and the initial burn-in period for calibrating the CreditGrades model. It also remains qualitatively unchanged during the earlier and less chaotic sample period of 2001–2004. Perhaps more interestingly, we identified significant cross-sectional variations in such relative performance. For instance, option-implied volatility provides much more added value in terms of improved CDS pricing performance when the company in question has a lower credit rating, a more volatile CDS spread, and larger options-trading volume. Our interpretation is that these characteristics are associated with a higher signal-to-noise ratio of options market information. Our findings are important to market participants who need to monitor their credit risk exposures constantly. The improvement in pricing performance is likely to result in fewer false trading signals and superior profitability for capital structure arbitrageurs. On a more fundamental level, our findings suggest that having forward-looking inputs from the market could be as important as having the right model for pricing credit risk.

Assessing Models of Individual Equity Option Prices

This article investigates option models in the encompassing class of stochastic volatility, return-jumps, and volatility-jumps. Relying on individual equity options on the 50 most active firms and maximum likelihood estimation method, we obtain several findings. First, while stochastic volatility is as important for individual equity options as it is for index options, return-jumps and volatility-jumps are also essential in pricing individual equity options. Second, the double-jump model improves pricing performance beyond return-jumps absent volatility-jumps, and beyond volatility-jumps absent return-jumps. Third, between return-jumps and volatility-jumps, the former is empirically more relevant than the latter for pricing options; and fourth, the inverse link between volatility-jumps and return-jumps is instrumental for explaining the valuation of deep out-of-money puts and the option dynamics of firms with high kurtosis.

Funding Liquidity Shocks in a Natural Experiment: Evidence from the CDS Big Bang

The CDS Big Bang (the protocol changes for the CDS market in April 2009) increased the upfront funding requirements for trading CDS contracts, especially for those with credit spreads further away from 100 and 500 basis points. Exploiting this natural experiment, we document direct evidence that a higher funding requirement reduces market liquidity, increases the absolute value of the CDS-bond basis, and CDS spread volatility. Our evidence highlights an unintended consequence of the ongoing standardization of OTC markets — while its intention is to reduce systemic risk, standardization may jeopardize market liquidity precisely during periods of financial distress.

Price Discrimination Against Retail Investors: Evidence from Mini Options

This paper studies the rise and fall of “Mini�? options that are especially catered to retail investors for popular but high-priced securities. Using transaction-level data, we find that transaction costs of Mini options are much higher than those of standard options and the difference cannot be fully explained by cost-related determinants. Furthermore, we find evidence of price discrimination against retail investors from analyses of price elasticities of option traders, an event-study of changes in bid-ask spreads around earnings announcements, and comparisons of trade prices paid by Mini and standard option traders for the same security at approximately the same time.

Economic Policy Uncertainty, CDS Spreads, and CDS Liquidity Provision

Using a news-based index of economic policy uncertainty (EPU), we find that EPU is positively associated with credit default swap (CDS) spreads and negatively associated with the number of liquidity providers in the CDS market. A 10% increase in EPU leads to an 8.4% increase in CDS spreads and a 4.0% decrease in the number of liquidity providers. Furthermore, the effects of EPU are persistent and robust after controlling for macroeconomic variables. Our results are also robust to different econometric methodologies. Overall, our findings suggest that, when EPU is high, investors find credit protection more costly and difficult to purchase.