Can Higher-Order Risks Explain the Credit Spread Puzzle?

51 Pages Posted: 1 Jun 2016  

Cedric Okou

University of Quebec at Montreal (UQAM)

Olfa Maalaoui Chun

Korea Advanced Institute of Science and Technology (KAIST) - Graduate School of Finance

Georges Dionne

HEC Montreal - Department of Finance

Jingyuan Li

Lingnan University - Department of Finance and Insurance

Date Written: May 11, 2016

Abstract

We tweak the conventional Merton model to account for the asymmetric properties of assets returns and investors asymmetric behavior toward the upside potential of gain versus the downside risk of loss. Using an asymmetric split normal distribution, we capture empirical asymmetries in the underlying return distribution, while we conserve the attractiveness of delivering closed-form pricing formulas that collapse to the basic Merton model in the symmetric Gaussian case. The asymmetric specification outperforms the symmetric one in matching high levels of historical credit spreads. We then link the residual (non-default-model-implied) spread to two illiquidity risk factors. The first factor is extracted from several measures of idiosyncratic illiquidity variables and the second factor is a systematic factor obtained from a general index common to all studied bonds. Our model explains 70% of the BBB-AAA spread and more than 72% of BBB and AAA credit spreads relative to the on-the-run Treasury rates.

Keywords: Credit Spread Puzzle, Asymmetry, Illiquidity, Higher-Order Risks

JEL Classification: D51; D80; G12

Suggested Citation

Okou, Cedric and Maalaoui Chun, Olfa and Dionne, Georges and Li, Jingyuan, Can Higher-Order Risks Explain the Credit Spread Puzzle? (May 11, 2016). Available at SSRN: https://ssrn.com/abstract=2787412 or http://dx.doi.org/10.2139/ssrn.2787412

Cedric Okou

University of Quebec at Montreal (UQAM) ( email )

PB 8888 Station DownTown
Succursale Centre Ville
Montreal, Quebec H3C3P8
Canada
514-987-3000 Ext. 5521 (Phone)

Olfa Maalaoui Chun

Korea Advanced Institute of Science and Technology (KAIST) - Graduate School of Finance ( email )

207-43 Cheongryangri-2dong 130-722
Seoul
Korea

Georges Dionne (Contact Author)

HEC Montreal - Department of Finance ( email )

3000 Chemin de la Cote-Sainte-Catherine
Montreal, Quebec H3T 2A7
Canada
514-340-6596 (Phone)
514-340-5019 (Fax)

HOME PAGE: http://www.hec.ca/gestiondesrisques/

Jingyuan Li

Lingnan University - Department of Finance and Insurance ( email )

Castle Peak Road
Tuen Mun, New Territories
Hong Kong
China

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