Option-based Credit Spreads

Dr. Yoshio Nozawa

Federal Reserve Board

About the Speaker

Yoshio Nozawa is a senior economist at the Federal Reserve Board. His research area is empirical asset pricing focusing on pricing of credit risk and options. He obtained his PhD in finance and economics from the University of Chicago in 2013. Prior to the graduate school, he worked for Development Bank of Japan in Tokyo, trading bonds and derivatives.

About the Seminar

We present a novel empirical benchmark for analyzing credit risk using “pseudo firms” that purchase traded assets financed with equity and zero-coupon bonds. By no-arbitrage, the bonds are equivalent to Treasuries minus put options on pseudo-firm assets. Empirically, like corporate spreads, pseudo-bond spreads are large, countercyclical, and predict lower economic growth. Using this framework, we find that bond market illiquidity, investors’ over-estimation of default risks, corporate frictions, and constraints on aggregate credit supply do not seem to explain excessive observed credit spreads, but, instead, a risk premium for tail and idiosyncratic asset risks is the primary determinant of corporate spreads.