Downside Risk, Liquidity and the Size of Credit Spreads

36 Pages Posted: 16 Feb 2009 Last revised: 25 Oct 2009

See all articles by Aneel Keswani

Aneel Keswani

Faculty of Finance, Cass Business School, City University, London

Gordon Gemmill

Warwick Business School

Date Written: October 22, 2009

Abstract

We use a panel of investment-grade bonds to investigate why credit spreads are so much larger than expected losses from default. We find that systematic factors contribute little to spreads, even if higher moments or downside effects are incorporated. Instead, two idiosyncratic risk factors, bond volatility and bond value-at-risk (BVaR), have surprisingly strong explanatory power, even after controlling for equity volatility (as used by Campbell and Taksler, 2003). Bond volatility helps explain spreads because it proxies for liquidity risk. BVaR’s explanatory power is due to the risk-neutral left-skewness of firm value, which makes a large contribution to spreads, particularly for the highest-rated bonds. Overall, credit spreads are large mainly because investors are averse to extreme losses on the downside.

Keywords: Bond, idiosyncratic risk, downside risk, value-at-risk, credit spread puzzle, pricing kernel, Merton model, liquidity

JEL Classification: G12

Suggested Citation

Keswani, Aneel and Gemmill, Gordon, Downside Risk, Liquidity and the Size of Credit Spreads (October 22, 2009). Available at SSRN: https://ssrn.com/abstract=1342441 or http://dx.doi.org/10.2139/ssrn.1342441

Aneel Keswani

Faculty of Finance, Cass Business School, City University, London ( email )

106 Bunhill Row
London EC1Y 8TZ
Great Britain
+44 207 040 8763 (Phone)

Gordon Gemmill (Contact Author)

Warwick Business School ( email )

Coventry CV4 7AL
United Kingdom

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