International Finance Discussion Papers (IFDP)

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August 2017

Firm-specific risk-neutral distributions: The role of CDS spreads

Sirio Aramonte, Mohammad R. Jahan-Parvar, Samuel Rosen, and John W. Schindler

Abstract:

We propose a method to extract individual firms' risk-neutral return distributions by combining options and credit default swaps (CDS). Options provide information about the central part of the distribution, and CDS anchor the left tail. Jointly, options and CDS span the intermediate part of the distribution, which is driven by moderatesized jump risk. We study the returns on a trading strategy that buys (sells) stocks exposed to positive (negative) moderate-sized jump risk unspanned by options or CDS individually. Controlling for many known factors, this strategy earns a 0.5% premium per month, highlighting the economic value of combining options and CDS.

Keywords: risk neutral distributions; CDS spreads; cross-section of expected returns

DOI: https://doi.org/10.17016/IFDP.2017.1212

PDF: Full Paper

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Last Update: January 09, 2020