Downside Risk, Liquidity and the Size of Credit Spreads
36 Pages Posted: 16 Feb 2009 Last revised: 25 Oct 2009
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: Suggested Citation
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