This study investigates the information content of implied volatilities extracted from OTC individual equity put options to explain credit default swap (CDS) spread in Korea market. Using out-of-the money put option quotes for 13 firms over the period from January 2006 to August 2009, we demonstrate that the implied volatility dominates historical volatility in explaining the time-series variation in CDS spreads but its effect is partially subsumed by that of credit market illiquidity. Also, we find that even though the cross-sectional average coefficient of implied volatility is marginally significant and a biased estimator in forecasting future realized volatilities, the predicted future volatility inferred from implied volatility is a significant determinant of CDS spreads in the out-of-sample approach. Moreover, the rescaled volatility risk premium, defined as the difference between the implied volatility and the predicted future volatility divided by the predicted volatility, co-varies with the CDS spreads. These findings suggest that due to the information to predict future volatility and the volatility risk premium embedded in put option price, the implied volatility has better explanatory power than historical volatility for explaining CDS spreads.
JEL classification: G11, G12, G14.
Keywords: Credit default swap; out-of-the money put option; implied volatility; historical volatility; volatility risk premium; predicted future volatility.
