Ambiguity, Volatility, and Credit Risk

Patrick Augustin, Yehuda Izhakian and Stijn Van Nieuwerburgh

The Review of Financial Studies, 2020, vol. 33, issue 4, 1618-1672

Abstract: We explore the implications of ambiguity for the pricing of credit default swaps (CDSs). A model of heterogeneous investors with independent preferences for ambiguity and risk shows that, because CDS contracts are assets in zero net supply, the net credit risk exposure of the marginal investor determines the sign of the impact of ambiguity on CDS spreads. We find that ambiguity has an economically significant negative impact on CDS spreads, on average, suggesting that the marginal investor is a net buyer of credit protection. A 1-standard-deviation increase in ambiguity is estimated to decrease CDS spreads by approximately 6%.

Date: 2020
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