A Credit Spread Puzzle for Reduced-Form Models

Antje Berndt

The Review of Asset Pricing Studies, 2015, vol. 5, issue 1, 48-91

Abstract: Reduced-form models of default calibrated to expected default losses and comovements between default losses and an equity-based pricing kernel generate CDS spreads that tend to fall below historical values. In frictionless markets, resolving this credit spread puzzle requires credit-market investors, especially those in high-quality debt, to be more risk adverse than equity-market investors. In the absence of market segmentation, however, the puzzle points to a liquidity component that, depending on the model specification, can account for more than half of historical CDS spreads. These findings caution against fitting reduced-form models to CDS spreads without accounting for market segmentation or frictions.

JEL-codes: G12 G13 G22 G24 (search for similar items in EconPapers)
Date: 2015
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Citations: View citations in EconPapers (7)

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