Volatility information difference between CDS, options, and the cross section of options returns

Abstract

We examine the difference in the information content in credit and options markets by extracting volatilities from corporate credit default swaps (CDSs) and equity options. The standardized difference in volatility, quantified as the volatility spread, is positively related to future option returns. We rank firms based on the volatility spread and analyze the returns for straddle portfolios buying both a put and a call option for the underlying firm with the same strike price and expiration date. A zero-cost trading strategy that is long (short) in the portfolio with the largest (smallest) spread generates a significant average monthly return, even after controlling for individual stock characteristics, traditional risk factors, and moderate transaction costs.

Keywords:

• Implied volatility
• CDS
• Equity returns
• Equity option

JEL Classification:

• C11
• C12
• C13
• G11
• G12

Acknowledgements

We thank the seminar participants at the 7th International Conference on Futures and Other Derivatives for their insightful comments, all errors are ours.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 Note that option returns are computed only for those which are close to being at-the-money (ATM). We use deeply out-of-the-money put options only to compute the Z-score.

2 On average, the half-life of the decay is equal to 1.2 months, which measures the expected time it takes for the spread to revert to half its initial deviation from the mean. This determines the optimal holding period for a mean-reverting position.

Additional information

Funding

Biao Guo acknowledges the support by the Fundamental Research Funds for the Central Universities and the Research Funds of Renmin University of China [grant number 16XNA001].