We examine the difference in the information content in credit and options markets by extracting volatilities from corporate credit default swaps (CDSs) and equity options. The standardized difference in volatility, quantified as the volatility spread, is positively related to future option returns. We rank firms based on the volatility spread and analyze the returns for straddle portfolios buying both a put and a call option for the underlying firm with the same strike price and expiration date. A zero-cost trading strategy that is long (short) in the portfolio with the largest (smallest) spread generates a significant average monthly return, even after controlling for individual stock characteristics, traditional risk factors, and moderate transaction costs.

【Keywords】

Implied volatility; CDS; equity returns; equity option

Biao Guo, Research Fellow of IMI, is at the School of Finance & China Financial Policy Research Center, Renmin University of China.

Yukun Shi, the Accounting and Finance department of Adam Smith Business School, University of Glasgow.

Yaofei Xu, the University of Glasgow.