Ambiguity and Corporate Yield Spreads
56 Pages Posted: 27 Mar 2022
Date Written: March 24, 2022
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: Suggested Citation