Does Fundamental Volatility Help Explain Credit Risk?

November 10, 2015
  • Contributors:

    Maria Correia, Johnny Kang, Scott A. Richardson
  • Topic:

    Fixed Income

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 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 generate superior out-of-sample forecasts of bankruptcy and are better able to explain cross-sectional variation in corporate bond and corporate CDS spreads for a large sample of U.S. corporate issuers.



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