Ambiguity and Corporate Yield Spreads

56 Pages Posted: 27 Mar 2022

See all articles by Yehuda (Yud) Izhakian

Yehuda (Yud) Izhakian

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

Ryan Lewis

University of Colorado, Boulder

Jaime F. Zender

University of Colorado at Boulder - Department of Finance

Date Written: March 24, 2022

Abstract

We derive a model of bond pricing under ambiguity, showing that ambiguity interacts with risk to determine spreads. Since default is an inherently "unfavorable" outcome, ambiguity-averse bondholders overweigh its probability and demand higher yields for bonds with higher ambiguity.

Empirically, the economic effect of ambiguity on credit spreads is of the same magnitude as that of risk. Furthermore, ambiguity and risk amplify each-other; spreads on higher risk bonds are more sensitive to ambiguity and vice versa. Incorporating ambiguity substantially improves the model's fit relative to observed spreads, providing a potential resolution to the credit spread puzzle.

Keywords: Yield Spreads, Knightian Uncertainty, Ambiguity Aversion, Bond Ambiguity, Perceived Probabilities.

JEL Classification: C65, D81, D83, G12, G32

Suggested Citation

Izhakian, Yehuda (Yud) and Lewis, Ryan and Zender, Jaime F., Ambiguity and Corporate Yield Spreads (March 24, 2022). Available at SSRN: https://ssrn.com/abstract=4066052 or http://dx.doi.org/10.2139/ssrn.4066052

Yehuda (Yud) Izhakian (Contact Author)

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/

Ryan Lewis

University of Colorado, Boulder ( email )

Boulder, CO 80309-0419
United States

Jaime F. Zender

University of Colorado at Boulder - Department of Finance ( email )

Boulder, CO 80309
United States
303-554-1665 (Phone)
303-492-4689 (Fax)

HOME PAGE: http://www-bus.colorado.edu/faculty/Zender/

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