Journal Article

Inflation Uncertainty, Asset Valuations, and the Credit Spreads Puzzle

Alexander David

in The Review of Financial Studies

Published on behalf of The Society for Financial Studies

Volume 21, issue 6, pages 2487-2534
Published in print November 2008 | ISSN: 0893-9454
Published online September 2007 | e-ISSN: 1465-7368 | DOI: http://dx.doi.org/10.1093/rfs/hhm041
Inflation Uncertainty, Asset Valuations, and the Credit Spreads Puzzle

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  • Multiple or Simultaneous Equation Models; Multiple Variables
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Investors' learning of the state of future real fundamentals from current inflation leads to macroeconomic state dependence of asset valuations and solvency ratios of firms within given rating categories. Since credit spreads are convex functions of solvency ratios, average spreads are higher than spreads at average solvency ratios. Macroeconomic shocks carry risk premiums so that expected default losses are more sensitive to changes in the price of risk than are credit spreads. By incorporating state dependence and increasing the price of risk, the econometrician obtains high credit spreads while maintaining average default losses at historical levels—the credit spreads puzzle.

Keywords: G12; G13; G14; C3; C5

Journal Article.  21007 words.  Illustrated.

Subjects: Economics ; Multiple or Simultaneous Equation Models; Multiple Variables ; Econometric Modelling

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