A Credit Spread Puzzle for Reduced-Form Models
60 Pages Posted: 23 Mar 2014 Last revised: 30 Apr 2015
Date Written: February 28, 2015
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: Suggested Citation