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Bridge over ocean
26 April 2025 Financial Analysts Journal Volume 81, Issue 2

Credit-Implied Volatility

  1. Bryan T. Kelly
  2. Gerardo Manzo
  3. Diogo Palhares

The credit-implied volatility (CIV) surface is introduced as an organizing framework for analysis of credit spreads, providing a description of CDS spreads for firms across the credit spectrum, of varying maturities, and at all points throughout the credit cycle.

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Abstract

We define and construct a credit-implied volatility (CIV) surface from the firm-by-maturity panel of credit default swap (CDS) spreads. We use this framework to organize the behavior of corporate credit markets into three stylized facts. First, CIV exhibits a steep moneyness smirk. Second, the joint dynamics of credit spreads on all firms are captured by three interpretable factors in the CIV surface. Third, the cross-section of CDS risk premia is fully explained by exposures to CIV surface shocks. We propose a structural model for joint asset behavior of all firms that is characterized by stochastic volatility and time-varying downside tail risk in aggregate asset growth.