The Term Structure of Credit Default Swap Spreads and the Cross Section of Options Returns

This paper uses log Credit Default Swap (CDS) slope to explore the 1-month ATM deltahedged
straddle return variation at cross-section. The cross-sectional 1-month ATM delta-hedged
straddle return is significantly and positively predicted by log CDS slope, even after controlling
several notable volatility mispricing factors. When looking deeper on this forecasting relationship,
this paper finds the cross-sectional forecasting relationship between straddle return and log CDS
slope exists a strong time-varying pattern, highly depending on the market condition. However,
the relationship between several notable volatility mispricing factors and straddle return tends to
be stable over time. Through constructing the long-short trading portfolio on straddle options,
this paper confirms, the trading performance is much better when past 12m market return is at a
historical lower level, past 12m market volatility is at a historical higher level, and VIX is at a
historical higher level. This indicates the log CDS slope tends to be more related to the option
price mispricing at cross-section when market is much risker.