Ambiguity, Volatility, and Credit Risk

Review of Financial Studies, Forthcoming

86 Pages Posted: 7 May 2016 Last revised: 19 Apr 2019

See all articles by Patrick Augustin

Patrick Augustin

McGill University, Desautels Faculty of Management

Yehuda (Yud) Izhakian

City University of New York, Baruch College - Zicklin School of Business - Department of Economics and Finance

Date Written: April 15, 2019

Abstract

We explore the implications of ambiguity for the pricing of credit default swaps (CDSs). A model of heterogeneous investors with independent preferences for ambiguity and risk shows that, since CDS contracts are assets in zero net supply, the net credit risk exposure of the marginal investor determines the sign of the impact of ambiguity on CDS spreads. We find that ambiguity has an economically significant negative impact on CDS spreads, on average, suggesting that the marginal investor is a net buyer of credit protection. A one standard deviation increase in ambiguity is estimated to decrease CDS spreads by approximately 6%.

Keywords: CDS, Derivatives, Heterogeneous Agents, Insurance, Knightian uncertainty, Risk aversion

JEL Classification: C65, D81, D83, G13, G22

Suggested Citation

Augustin, Patrick and Izhakian, Yehuda (Yud), Ambiguity, Volatility, and Credit Risk (April 15, 2019). Review of Financial Studies, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2776377 or http://dx.doi.org/10.2139/ssrn.2776377

Patrick Augustin (Contact Author)

McGill University, Desautels Faculty of Management ( email )

1001 Sherbrooke Street West
Quebec
Montreal, Quebec H3A 1G5
Canada

HOME PAGE: http://www.patrickaugustin.se

Yehuda (Yud) Izhakian

City University of New York, Baruch College - Zicklin School of Business - Department of Economics and Finance ( email )

17 Lexington Avenue
New York, NY 10010
United States

HOME PAGE: http://people.stern.nyu.edu/yizhakia/

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