Volatility morphology of asset value and credit spread puzzle

Xiao Hu, Xinming Tian and Kuitai Wang
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Xiao Hu: School of Finance, Southwestern University of Finance and Economics, Chengdu, Sichuan 611130, P. R. China
Xinming Tian: International Monetary Institute, Renmin University of China, Beijing 100872, P. R. China3Department of Fixed Income, Rongtong Fund Management Co., Ltd., Beijing 100032, P. R. China
Kuitai Wang: School of Finance, Southwestern University of Finance and Economics, Chengdu, Sichuan 611130, P. R. China

International Journal of Financial Engineering (IJFE), 2021, vol. 08, issue 03, 1-16

Abstract: Merton model has provided a classic theoretical framework for explaining credit spreads. This paper extends Merton model by introducing morphology factor of asset value volatility in the model, and conducts empirical studies on the effect of asset volatility morphology on credit spreads in China’s bond market. The results show that asset volatility morphology is economically important and can explain credit spreads well. Furthermore, this paper analyzes the asymmetric influences of monetary policy on credit spreads and asset volatility morphology. This paper points out that the responses of credit spreads and asset volatility morphology to monetary policy are consistent in the tight liquidity environments. To this end, monetary policy and liquidity, which are two factors that have been ignored by classic Merton model but proved to have significant influences on credit spreads, play roles in influencing credit spreads by changing volatility morphology of asset value. Since asset volatility morphology can reflect the change of investors’ expectation on the default probability of asset, the argument mentioned in the credit spread puzzle that the fundamentals related to bond default probability cannot explain credit spreads needs to be reexamined.

Keywords: Bond market; credit spread puzzle; Merton model; monetary policy; volatility morphology (search for similar items in EconPapers)
Date: 2021
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DOI: 10.1142/S242478632142007X

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