Journal Article

A Credit Spread Puzzle for Reduced-Form Models

Antje Berndt

in The Review of Asset Pricing Studies

Volume 5, issue 1, pages 48-91
Published in print June 2015 | ISSN: 2045-9920
Published online March 2015 | e-ISSN: 2045-9939 | DOI: https://dx.doi.org/10.1093/rapstu/rav002
A Credit Spread Puzzle for Reduced-Form Models

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Reduced-form models of default calibrated to expected default losses and comovements between default losses and an equity-based pricing kernel generate CDS spreads that tend to fall below historical values. In frictionless markets, resolving this credit spread puzzle requires credit-market investors, especially those in high-quality debt, to be more risk adverse than equity-market investors. In the absence of market segmentation, however, the puzzle points to a liquidity component that, depending on the model specification, can account for more than half of historical CDS spreads. These findings caution against fitting reduced-form models to CDS spreads without accounting for market segmentation or frictions. (JEL G12, G13, G22, G24)

Journal Article.  16994 words.  Illustrated.

Subjects: Asset Pricing

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