A Joint Analysis of the Term Structure of Credit Default Swap Spreads and the Implied Volatility Surface

This paper presents a joint analysis of the term structure of credit default swap (CDS) spreads and the implied volatility surface. The rapid development of the CDS market has provided convenient products to extract credit risk, and its interaction with equity volatility has been analyzed in many studies. However, in most of them the 5-year credit default swap spread is used to measure credit risk, whilst the at-the-money 1-month implied volatility is used to measure equity volatility. Only very few studies analyze the entire smile as well as the term structure of CDS spreads. The purpose of this paper is to study the co-movements of the term structure of credit default swap spreads and the implied volatility surface. We perform a factor decomposition for both the dynamics of the implied volatility surface and the CDS curve. Then we jointly analyze the factors. More precisely, we compute the information flow between the credit and volatility factors and complete the study by analyzing the contemporaneous interactions. Using time series of options and CDS curves for the U.S. and European markets, we find the following results: the credit market is the main contributor of overall market innovations. The empirical study highlights the existing cross-market linkages during the Global Financial Crisis. Our methodology is parsimonious and allows to capture the intrinsic relationships between the two markets with some important modeling consequences. JEL Classification: C14, C58, G12, G13.