Time-Varying Asset Volatility and the Credit Spread Puzzle
50 Pages Posted: 29 Nov 2016 Last revised: 21 Mar 2018
Date Written: March 17, 2018
Most extant structural credit risk models underestimate credit spreads while matching default rates, recoveries, leverage, and equity risk premia - a shortcoming known as the credit spread puzzle. We calibrate and estimate a model able to explain medium to long-term credit spreads by incorporating priced stochastic volatility. The model’s ability to explain short term spreads is improved by introducing priced jumps in firms’ asset values as well as adjusting for their bid-ask spreads. In addition, we extend the model to study the influence of volatility risk premia on a firm’s default and capital structure decisions.
Keywords: Asset Volatility, Credit Spread Puzzle, Structural Models
JEL Classification: G12
Suggested Citation: Suggested Citation