Article ID: | iaor20114111 |
Volume: | 185 |
Issue: | 1 |
Start Page Number: | 45 |
End Page Number: | 73 |
Publication Date: | May 2011 |
Journal: | Annals of Operations Research |
Authors: | Paradi Joseph, Elkhodiry Angie, Seco Luis |
Keywords: | credit, derivatives, options |
The evolution of credit derivatives has inspired many researchers to investigate the behaviour of credit spreads. Today the growing consensus is that the equity option market provides sufficient information to estimate latent credit parameters. Hull et al. (2005) propose a clever approach to estimate credit spreads from the equity option market. In this paper we first perform a time series analysis to test the conjecture of an existing relationship between credit spreads and implied equity volatility and find strong evidence of a positive relationship. We also propose an extension to Hull et al.’s paper that significantly improves credit spread estimation.