Credit Implied Volatility

, University of 黑料传送门 Booth School of Business

, University of 黑料传送门 Booth School of Business

Diogo Palhares

We study the credit implied volatility (CIV) surface. We invert it each month from the firm-by-maturity panel of CDS spreads via the Merton model, transforming CDS spreads into asset volatility units. CIV facilitates direct comparison of CDS prices for contracts with different 鈥渕oneyness鈥� (firm leverage) and different time to maturity. Analysis of the surface reveals new stylized facts in credit markets. First, CIV exhibits a steep moneyness smirk: Low leverage (out-of-the money) CDS trade at a large implied volatility premium relative to highly levered (at-the-money) CDS, holding other firm characteristics fixed. Second, the surface follows cyclical patterns and is driven by three dominant factors. In recessionary episodes, the moneyness smirk flattens as implied volatilities of high leverage firms rise faster than low leverage firms. This pattern is strongest for short maturity CDS, which twists the surface鈥檚 shape over time. The ability to match the shape and dynamics of the CIV surface is a simple and easy-to-visualize diagnostic for evaluating whether a candidate credit risk model can simultaneously price spreads of many diverse firms and contract maturities. We propose a joint structural model for the asset growth processes of all firms in the economy that provides an accurate fit of the empirical CIV surface