The Information Content of Option Volatility for Credit Default Swap

The growing academic literature highlights the information content of equity and currency options, and credit default swaps. Our findings will focus on a special role of option market information in explaining CDS spreads. Thus, we perform time-series regressions of CDS spreads on either implied or historical volatility of equity and currency markets using a broad sample of 1,570 daily observations for the period January 2006 to March 2012. Using data on sovereign CDS spreads, stock, and currency options, this study examines the relation between CDS, currency, and equity option volatilities. It is necessary to investigate which market options enhance the explanation power for determinants of CDS spread, and whether implied volatilities dominate historical volatilities in the determinants of CDS spread. Using time-series regressions, we find that currency market options enhance the explanation power for determinants of sovereign CDS spread, and that implied volatility dominates historical volatility in explaining CDS spreads. We find also the volatility skew of stock and currency options to be a significant determinant of CDS spreads. With this list of additional volatility variables included in the regressions, the explanation power of the time-series regressions has increased.