TAILIEUCHUNG - The Impact of Credit Risk and Implied Volatility on Stock Returns

As a matter of sound investment practice, FHLBanks should be able to measure the price sensitivity for individual securities and for the entire portfolio. In general, techniques used to measure the risk of individual securities are also appropriate for the entire portfolio. To estimate portfolio sensitivity, FHLBanks generally use, at a minimum, duration. Because of the presence of options in most portfolios, duration may not be an effective risk measure. Because of negative convexity, due to the existence of options in the portfolio, a portfolio may gain 2 percent when rates fall 100 basis points. | The Impact of Credit Risk and Implied Volatility on Stock Returns Florian Steiger1 Working Paper May 2010 JEL Classification G10 G12 G17 Abstract This paper examines the possibility of using derivative-implied risk premia to explain stock returns. The rapid development of derivative markets has led to the possibility of trading various kinds of risks such as credit and interest rate risk separately from each other. This paper uses credit default swaps and equity options to determine risk premia which are then used to form portfolios that are regressed against the returns of stock portfolios. It turns out that both credit risk and implied volatility have high explanatory power in regard to stock returns. Especially the returns of distressed stocks are highly dependent on credit risk fluctuations. This finding leads to practical implications such as cross-hedging opportunities between equity and credit instruments and potentially allows forecasting stock returns based on movements in the credit market. 1 Author Florian Steiger e-mail Contents Table of 1 Problem Definition and Course of the 2 Asset Pricing Models and Derivative The Multifactor The Advantages of Derivative Markets for Asset Pricing 3 Implied Volatility and CDS Spreads as Risk Implied The Black-Scholes Determining the Implied Implied Volatility and Stock The CDS Spread and Stock 4 Impact of Credit Risk and Implied Volatility on Stock Credit Risk and Implied Volatility as Risk Analytic Stock Econometric Determination of Risk The Risk Premium for CDS The Risk Premium for Implied Regression CDS .

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