Title: Extracting risk neutral distributions using option prices and CDS spreads
Authors: Sirio Aramonte - Federal Reserve Board (United States)
Mohammad Jahan-Parvar - Federal Reserve Baord of Governors (United States) [presenting]
Samuel Rosen - UNC Chapel Hill - Kenan-Flagler Business School (United States)
John Schindler - Federal Reserve Board (United States)
Abstract: A methodology is proposed to estimate the risk-neutral distribution of a firm's expected stock returns by blending option prices and CDS spreads, with the former providing information about the central part of the distribution, and the latter determining the left tail. We apply the methodology to a sample of risky U.S. firms. We assess the economic value of estimating risk-neutral distributions with both options and CDS by forming a long-short portfolio based on the lagged difference between the option-CDS skewness and the option-only skewness. The strategy generates significant abnormal returns, gross of transaction costs, after controlling for a large set of relevant factors. The results are especially strong in the 2008-2011 period, which includes the 2008 financial crisis, the Greek debt crisis, and the 2011 debt ceiling event.