Explaining the level of credit spreads: option-implied jump risk premia in a firm value model

On 9-10 September 2004, the BIS held a workshop on
The pricing of credit risk. This event brought together central
bankers, academics and market practitioners to exchange views on this issue
(see the conference programme in this document). This paper was presented at
the workshop. The views expressed are those of the author(s) and not those of
the BIS.

Abstract:

Prices of equity index put options contain information on the price of
systematic downward jump risk. We use a structural jump-diffusion firm value
model to assess the level of credit spreads that is generated by option-implied
jump risk premia. In our compound option pricing model, an equity index option
is an option on a portfolio of call options on the underlying firm values. We
calibrate the model parameters to historical information on default risk, the
equity premium and equity return distribution, and S&P 500 index option
prices. Our results show that a model without jumps fails to fit the equity
return distribution and option prices, and generates a low out-of-sample
prediction for credit spreads. Adding jumps and jump risk premia improves the
fit of the model in terms of equity and option characteristics considerably and
brings predicted credit spread levels much closer to observed levels.

JEL classification: G12, G13

Keywords: credit spreads, firm value model, jump-diffusion model, option
pricing