Decomposing Swap Spreads

The information content of option-implied volatility for credit default swap valuation

“…The coefficient of the Baa yield is positive and significant, which can be attributed to the close relation between bond and CDS markets (Longstaff et al, 2005;Blanco et al, 2005). The coefficient of the credit market illiquidity factor is positive and significant, consistent with the ''flight-to-quality'' interpretation of the Feldh¨utter and Lando (2008) Treasury convenience yield factor. Lastly, none of the market volatility variables is significant, which suggests that the information content of market-level volatilities is subsumed by firm-level volatilities.…”

“…Credit market illiquidity. Feldh¨utter and Lando (2008) decompose the 10-year swapTreasury spread into several components, one of which measures the convenience yield from holding Treasury securities. Because this component is likely to be large as investors flee the credit market and seek refuge in the Treasury market, we take it as a measure of credit market illiquidity.…”

“…In our benchmark regression, we include both the implied volatility (IV ) and the 252-day historical volatility (HV), as well as additional control 4 We are grateful to Peter Feldh¨utter and David Lando for sharing their Treasury convenience yield factor. Since our credit market illiquidity measure is constructed using a parametric model of the swap-Treasury spread (i.e., Feldh¨utter and Lando, 2008), in Section 5 we explore alternative measures of credit market illiquidity that are model-independent. These include the swap-Treasury spread itself, as well as the spread between on-and offthe-run 10-year Treasury yields.…”

“…Instead of using the Feldh¨utter and Lando (2008) Treasury convenience yield factor as a proxy of credit market illiquidity, which is derived from a parametric model of the Table 6 Time-series regression analysis of CDS spreads on predicted future volatility and volatility risk premium.…”

“…The first alternative measure we use is the swapTreasury spread itself, which has a tendency to increase during a credit market liquidity crunch. As shown by Feldh¨utter and Lando (2008), the swap-Treasury spread contains both liquidity risk and credit risk components, as well as a swap-specific component related to hedging activities in the mortgage-backed securities market. However, they show that the liquidity component is by far the largest and most variable part of the swapTreasury spread.…”