Understanding the cross-section of CDS returns using equity options

We examine the cross-section of credit default swap (CDS) returns by forming CDS portfolios based on the implied volatility curves of equity options. We document that CDS protection sellers earn higher average returns for: (1) firms with higher at-the-money implied volatility and (2) firms with steeper volatility skew when conditioning on high implied volatility. We find that, relative to bond returns, CDS returns are better explained by our proposed measures interacted with standard credit determinants. Our reasoning is that the large degree of informed trading in the CDS market makes it more in sync with the equity options market, which is also known to attract informed traders.