The Negative Credit Risk Premium Puzzle: A Limits to Arbitrage Story

Chris Godfrey and Chris Brooks
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Chris Godfrey: ICMA Centre, Henley Business School, University of Reading

ICMA Centre Discussion Papers in Finance from Henley Business School, University of Reading

Abstract: Prior research has documented that, counter-intuitively, high credit risk stocks earn lower not higher returns than low credit risk stocks. In this paper we provide evidence against rational expectations explanations, and show that a model incorporating limits-to-arbitrage factors is capable of explaining this apparent anomaly. We demonstrate that the negative pricing of credit stocks is driven by the underperformance of stocks which have both high credit risk and which have suffered recent relative underperformance, and that their ongoing poor performance can be explained by a mixture of four limits-to-arbitrage factors idiosyncratic risk, turnover, illiquidity and bid-ask spreads. Collectively, these impede the correction of mispricing by arbitrageurs, especially on the short leg of the trade, where commonly reported returns are unattainable.

Keywords: behavioural finance; relative distress; credit risk premium puzzle; asset pricing; limits to arbitrage (search for similar items in EconPapers)
JEL-codes: C31 C55 D03 G12 (search for similar items in EconPapers)
Date: 2015-09
New Economics Papers: this item is included in nep-upt
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Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:rdg:icmadp:icma-dp2015-07

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