Option-Based Credit Spreads

Abstract

We propose a non-parametric empirical benchmark for credit risk analysis. We build fictitious “pseudo firms” that purchase real traded assets by issuing equity and zero-coupon bonds. By no-arbitrage, these bonds equal Treasuries minus put options on the firms’ assets, whose values are all observable. We exploit our pseudo firms as a laboratory, and empirically show that their credit spreads are large and countercyclical, illiquidity and corporate frictions are unlikely determinants of bonds’ credit spreads, infrequent rating changes and idiosyncratic asset uncertainty greatly increase spreads, and, in a banking application, discount rate shocks substantially increase banks’ tail risks and default correlations.