Is the Credit Spread Puzzle a Myth?

49 Pages Posted: 22 Oct 2018 Last revised: 7 Dec 2018

See all articles by Jennie Bai

Jennie Bai

Georgetown University - Department of Finance

Robert S. Goldstein

University of Minnesota - Twin Cities - Carlson School of Management; National Bureau of Economic Research (NBER)

Fan Yang

University of Connecticut - Department of Finance

Date Written: October 1, 2018

Abstract

Structural models of default can identify asset value dynamics and the location of the default boundary from either (observable) credit spreads or (latent) default probabilities. The latter approach uses historical default rates as proxies, which provide such low statistical power that assumptions regarding asset value dynamics (e.g., geometric Brownian motion) typically go untested. In contrast, calibration via credit spreads offers much more power, and clearly detects jumps in (risk-neutral) asset value dynamics. A large market price of risk on jumps is required to match historical default rates, thus reaffirming a "credit spread puzzle" for investment-grade but not high-yield bonds.

Keywords: credit spread puzzle, structural models, tail risk

JEL Classification: C23, G12, G13

Suggested Citation

Bai, Jennie and Goldstein, Robert S. and Yang, Fan, Is the Credit Spread Puzzle a Myth? (October 1, 2018). Georgetown McDonough School of Business Research Paper; University of Connecticut School of Business Research Paper No. 18-28. Available at SSRN: https://ssrn.com/abstract=3262310 or http://dx.doi.org/10.2139/ssrn.3262310

Jennie Bai (Contact Author)

Georgetown University - Department of Finance ( email )

3700 O Street, NW
Washington, DC 20057
United States

HOME PAGE: http://www.jenniebai.com

Robert S. Goldstein

University of Minnesota - Twin Cities - Carlson School of Management ( email )

19th Avenue South
Minneapolis, MN 55455
United States
612-624-8581 (Phone)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Fan Yang

University of Connecticut - Department of Finance ( email )

School of Business
2100 Hillside Road
Storrs, CT 06269
United States

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