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Credit-Implied Forward Volatility and Volatility Expectations

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Abstract

We show how one can back out implied forward volatility term structures from credit default swap spreads. Such forward stock volatility term structures are useful for instance in forward start option pricing. We find the term structure to be downward-sloping, and the credit market's volatility forecasts tend to vary more across time than across maturities. Long-term volatility expectations, in turn, are found to be low and stable while short-term expectations are higher and more volatile. The volatility expectation’s mean-reversion rate, finally, indicates that the credit market expects volatility shocks in the equity market to last for several years.

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  • Byström, Hans, 2015. "Credit-Implied Forward Volatility and Volatility Expectations," Working Papers 2015:34, Lund University, Department of Economics.
    • Handle: RePEc:hhs:lunewp:2015_034
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    1. Paul Glasserman & Qi Wu, 2011. "Forward And Future Implied Volatility," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 14(03), pages 407-432.
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    6. Xu, Xinzhong & Taylor, Stephen J., 1994. "The Term Structure of Volatility Implied by Foreign Exchange Options," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 29(1), pages 57-74, March.
    7. Byström, Hans, 2013. "Stock Prices and Stock Return Volatilities Implied by the Credit Market," Working Papers 2013:25, Lund University, Department of Economics, revised 14 Feb 2014.
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    More about this item

    Keywords

    CDS; implied volatility term structure; forward volatility; forward start options;
    All these keywords.

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)

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