Time-Varying Asset Volatility and the Credit Spread Puzzle

50 Pages Posted: 29 Nov 2016 Last revised: 21 Mar 2018

See all articles by Du Du

Du Du

Hong Kong University of Science & Technology (HKUST)

Redouane Elkamhi

University of Toronto - Rotman School of Management

Jan Ericsson

McGill University; Swedish Institute for Financial Research (SIFR)

Date Written: March 17, 2018

Abstract

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

Du, Du and Elkamhi, Redouane and Ericsson, Jan, Time-Varying Asset Volatility and the Credit Spread Puzzle (March 17, 2018). Journal of Finance, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1787508 or http://dx.doi.org/10.2139/ssrn.1787508

Du Du

Hong Kong University of Science & Technology (HKUST) ( email )

Clearwater Bay
Kowloon, 999999
Hong Kong

Redouane Elkamhi

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada

Jan Ericsson (Contact Author)

McGill University ( email )

1001 Sherbrooke St. West
Montreal, Quebec H3A1G5 H3A 2M1
Canada
(514) 398-3186 (Phone)
(514) 398-3876 (Fax)

HOME PAGE: http://people.mcgill.ca/jan.ericsson/

Swedish Institute for Financial Research (SIFR)

Drottninggatan 89
SE-113 59 Stockholm, SE-113 60
Sweden

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