Same firm, two volatilities: How variance risk is priced in credit and equity markets

Credit variance risk premiums

“…Shorting credit variance swaps yields a monthly average return of $$0.58 \% $$ ($$0.73 \% $$), which is highly significantly different from zero ( t statistic $$=2.23$$ ($$=2.56$$)). Our results corroborate recent findings of Kita and Tortorice (2021) that credit investors are willing to pay a large premium for hedging against volatility risk but on the index instead of the firm level. However, we do not find support on the index level that this is especially the case for low‐levered firms as high‐yield CVP is larger in absolute magnitude than investment grade CVP.…”

“…Strikingly, CVP returns to its relative richness after the onset. This finding extends Kita and Tortorice's (2021) conjecture to the index level that investors regard CVP as a better proxy for catastrophic risk premiums than equity or fixed‐income variance risk premiums.…”

“…Our paper is related to various strands of the literature. First, our results extend findings by Kita and Tortorice (2021) to the index level. Credit indices are the most liquid and most traded credit derivatives in the world.…”

“…We find that investors pay high‐risk premiums to be insured against credit volatility risk. In contrast to Kita and Tortorice (2021), our analysis does not need to rely on a structural model, as it is completely model‐free and employs credit swaptions. Although we confirm the author's findings that CVP are larger than equity variance risk premiums, we do not find support that this relation is inversely related to the leverage ratio.…”