Working Paper

Does Fundamental Volatility Help Explain Credit Risk?

Topics - Fixed Income

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Does Fundamental Volatility Help Explain Credit Risk?

Working paper

Market-based volatility measures have the advantage of being available at frequent intervals, but they may be dominated by market-wide non-fundamental discount rate news (Shiller, 1981; 1984; Mankiw, Romer and Shapiro, 1985). Accounting-based measures provide a more direct measure of the underlying fundamental volatility of the firm, but they are sampled less often and may be open to distortions and measurement error.

This paper investigates whether combining market- and accounting-based measures of asset volatility may generate a superior enhanced measure of total asset volatility that is relevant for understanding credit risk. Meanwhile, accounting-based volatility measures may provide useful information to forecast liquidity-driven default.

The authors conclude that combining accounting- and market-based measures of asset volatility improve out-of-sample forecasts of bankruptcy and are useful in explaining cross-sectional variation in corporate bond and corporate CDS spreads for a large sample of U.S. corporate issuers.