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The credit spread puzzle

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  • Jeffery D Amato
  • Eli M Remolona
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    Abstract

    Why are spreads on corporate bonds much wider than would be implied by expected losses from default? Previous explanations of this puzzle have assumed that investors can diversify away the risk that actual losses in a corporate bond portfolio will exceed expected losses. However, the skewness in the distribution of corporate bond returns implies that achieving such diversification will require an extraordinarily large portfolio. We present evidence from the market for collateralised debt obligations suggesting that such large portfolios are unattainable. Hence, investors always face the risk that actual losses will exceed expectations. Credit spreads are so wide because they compensate investors for such risk.

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    Bibliographic Info

    Article provided by Bank for International Settlements in its journal BIS Quarterly Review.

    Volume (Year): (2003)
    Issue (Month): (December)
    Pages:

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    Handle: RePEc:bis:bisqtr:0312e

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    References

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    1. Edwin J. Elton, 2001. "Explaining the Rate Spread on Corporate Bonds," Journal of Finance, American Finance Association, vol. 56(1), pages 247-277, 02.
    2. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
    3. Paul Schultz, 2001. "Corporate Bond Trading Costs: A Peek Behind the Curtain," Journal of Finance, American Finance Association, vol. 56(2), pages 677-698, 04.
    4. Nickell, Pamela & Perraudin, William & Varotto, Simone, 2000. "Stability of rating transitions," Journal of Banking & Finance, Elsevier, vol. 24(1-2), pages 203-227, January.
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    Cited by:
    1. Ingo Fender & Janet Mitchell, 2005. "Structured finance: complexity, risk and the use of ratings," BIS Quarterly Review, Bank for International Settlements, June.
    2. Gann, Philipp & Laut, Amelie, 2008. "Einflussfaktoren auf den Credit Spread von Unternehmensanleihen," Discussion Papers in Business Administration 4231, University of Munich, Munich School of Management.
    3. Bada, Oualid & Kneip, Alois, 2014. "Parameter cascading for panel models with unknown number of unobserved factors: An application to the credit spread puzzle," Computational Statistics & Data Analysis, Elsevier, vol. 76(C), pages 95-115.
    4. Michael S. Gibson, 2004. "Understanding the risk of synthetic CDOs," Finance and Economics Discussion Series 2004-36, Board of Governors of the Federal Reserve System (U.S.).
    5. Ingo Fender & Martin Scheicher, 2009. "The pricing of subprime mortgage risk in good times and bad: evidence from the ABX.HE indices," BIS Working Papers 279, Bank for International Settlements.
    6. Alina Georgiana Manta Ph. D, 2011. "Empirical Study Regarding The Influence Of The Gdp And Interest Rate On The Non-Government Credit. Study Case For Romania," Annals of University of Craiova - Economic Sciences Series, University of Craiova, Faculty of Economics and Business Administration, vol. 4(39), pages 15-24, May.
    7. Jacob Gyntelberg & Eli M Remolona, 2006. "Securitisation in Asia and the Pacific: implications for liquidity and credit risks," BIS Quarterly Review, Bank for International Settlements, June.
    8. repec:onb:oenbwp:y::i:152:b:1 is not listed on IDEAS
    9. Gann, Philipp, 2009. "Liquidit├Ąt, Risikoeinstellung des Kapitalmarktes und Konjunkturerwartung als Preisdeterminanten von Collateralized Debt Obligations (CDOs) - Eine simulationsgest├╝tzte Analyse," Discussion Papers in Business Administration 10582, University of Munich, Munich School of Management.
    10. Gann, Philipp, 2008. "Der Internal Capital Adequacy Assessment Process als regulatorischer Treiber eines aktiven Kreditportfoliomanagements," Discussion Papers in Business Administration 4831, University of Munich, Munich School of Management.
    11. Eli M Remolona & Michela Scatigna & Eliza Wu, 2007. "Interpreting sovereign spreads," BIS Quarterly Review, Bank for International Settlements, March.
    12. Myles Brennan & Adam Kobor & Vidhya Rustaman, 2011. "Diversifying market and default risk in high grade sovereign bond portfolios," BIS Papers chapters, in: Bank for International Settlements (ed.), Portfolio and risk management for central banks and sovereign wealth funds, volume 58, pages 49-74 Bank for International Settlements.

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