A Credit Spread Puzzle for Reduced-Form Models

60 Pages Posted: 23 Mar 2014 Last revised: 30 Apr 2015

See all articles by Antje Berndt

Antje Berndt

Australian National University (ANU) - Research School of Finance, Actuarial Studies and Applied Statistics

Date Written: February 28, 2015

Abstract

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.

Keywords: CDS spreads, Expected losses, Credit risk premia, CDS liquidity, Market segmentation

JEL Classification: G12, G13, G22, G24

Suggested Citation

Berndt, Antje, A Credit Spread Puzzle for Reduced-Form Models (February 28, 2015). Available at SSRN: https://ssrn.com/abstract=2413011 or http://dx.doi.org/10.2139/ssrn.2413011

Antje Berndt (Contact Author)

Australian National University (ANU) - Research School of Finance, Actuarial Studies and Applied Statistics ( email )

Canberra, ACT 0200
Australia

HOME PAGE: http://www.cbe.anu.edu.au/about/staff-directory/?profile=Antje-Berndt

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