Asset Measurement Uncertainty and Credit Term Structure

47 Pages Posted: 6 Apr 2011

See all articles by Navneet Arora

Navneet Arora

American Century Investments

Scott A. Richardson

AQR Capital Management, LLC; London Business School

A. Irem Tuna

London Business School

Date Written: April 5, 2011

Abstract

In this paper, we test the impact of uncertainty in asset measurement on credit term-structure. The theory of Duffie and Lando (2001) suggests that the inability of creditors to assess asset values precisely will support the existence of non-zero short term credit spreads. Developments in recent years enable us to directly test this theory. First, the development of the credit default swap market allows for examination of more precise and cross-sectionally comparable short term credit spreads. Second, FAS 157, which requires detailed disclosures of the fair values of financial assets to be included in financial statements, provides us a proxy for asset measurement uncertainty. Third, the financial crisis over the last two years presents a natural setting where asset measurement uncertainty was in focus, allowing for powerful tests of the theory. For a sample of U.S. financial institutions over the period August 2007 to March 2009, we find strong support for the Duffie and Lando (2001) theory. Specifically, we find that asset measurement uncertainty, attributable to Level 2 and Level 3 financial assets, is a significant determinant of short term credit spreads. Our findings are robust to a variety of control variables and research design choices.

Suggested Citation

Arora, Navneet and Richardson, Scott Anthony and Tuna, Ayse Irem, Asset Measurement Uncertainty and Credit Term Structure (April 5, 2011). Available at SSRN: https://ssrn.com/abstract=1803184 or http://dx.doi.org/10.2139/ssrn.1803184

Navneet Arora

American Century Investments ( email )

1665 Charleston Road
Mountain View, CA 94043
United States

Scott Anthony Richardson (Contact Author)

AQR Capital Management, LLC ( email )

Greenwich, CT
United States

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom

Ayse Irem Tuna

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom

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