The Credit Volatility Puzzle
In recent years, a liquid market for options on a broad credit index (CDX) has developed. We study the extent to which these options are priced consistently with options on a broad equity index (SPX). We consider a structural credit risk model where firm assets follow a jump-diffusion process with idiosyncratic and systematic risk, and we derive analytical expressions for CDX and SPX options. Calibrating the model, we find that CDX options are overpriced relative to SPX options, especially in case of high-strike CDX options. We discuss possible sources of this apparent mispricing.