How Much of Corporate-Treasury Yield Spread is Due to Credit Risk?
Pennsylvania State University - University Park - Department of Finance
Cornell University - Samuel Curtis Johnson Graduate School of Management
September 12, 2012
Forthcoming in the Review of Asset Pricing Studies
14th Annual Conference on Financial Economics and Accounting (FEA); Texas Finance Festival; 2003 Western Finance Association Meetings
We show that credit risk accounts for only a small fraction of yield spreads for investment-grade bonds of all maturities, with the fraction lower for bonds of shorter maturities, and that it accounts for a much higher fraction of yield spreads for high yield bonds. This conclusion is shown to be robust across a wide class of structural models. We obtain such results by calibrating each of the models to be consistent with data on the historical default loss experience and equity risk premia, and demonstrating that different models predict similar credit risk premia under empirically reasonable parameter choices.
Number of Pages in PDF File: 57
Keywords: Credit risk, credit spread puzzle, time varying risk premia, jumps and stochastic asset volatility
JEL Classification: G0, C0
Date posted: January 15, 2004 ; Last revised: October 5, 2012