The Negative Credit Risk Premium Puzzle: A Limits to Arbitrage Story

47 Pages Posted: 17 Sep 2015

See all articles by Chris Godfrey

Chris Godfrey

University of Manchester - Alliance Manchester Business School

Chris Brooks

University of Reading - ICMA Centre

Date Written: September 11, 2015

Abstract

Prior research has documented that, counter-intuitively, high credit risk stocks earn lower – not higher – returns than low credit risk stocks. In this paper we provide evidence against rational expectations explanations, and show that a model incorporating limits-to-arbitrage factors is capable of explaining this apparent anomaly. We demonstrate that the negative pricing of credit stocks is driven by the underperformance of stocks which have both high credit risk and which have suffered recent relative underperformance, and that their ongoing poor performance can be explained by a mixture of four limits-to-arbitrage factors – idiosyncratic risk, turnover, illiquidity and bid-ask spreads. Collectively, these impede the correction of mispricing by arbitrageurs, especially on the short leg of the trade, where commonly reported returns are unattainable.

Keywords: behavioural finance, relative distress, credit risk premium puzzle, asset pricing, limits to arbitrage

JEL Classification: C31, C55, D03, G12

Suggested Citation

Godfrey, Chris and Brooks, Chris, The Negative Credit Risk Premium Puzzle: A Limits to Arbitrage Story (September 11, 2015). Available at SSRN: https://ssrn.com/abstract=2661232 or http://dx.doi.org/10.2139/ssrn.2661232

Chris Godfrey (Contact Author)

University of Manchester - Alliance Manchester Business School ( email )

Booth Street West
Manchester, M15 6PB
United Kingdom

Chris Brooks

University of Reading - ICMA Centre ( email )

Whiteknights Park
P.O. Box 242
Reading RG6 6BA
United Kingdom
+44 118 931 82 39 (Phone)
+44 118 931 47 41 (Fax)

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