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Downside risk and the size of credit spreads

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  • Gemmill, Gordon
  • Keswani, Aneel
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    Abstract

    We investigate why spreads on corporate bonds are so much larger than expected losses from default. Systematic factors make very little contribution to spreads, even if higher moments or downside effects are taken into account. Instead we find that sizes of spreads are strongly related to idiosyncratic-risk factors: not only to idiosyncratic equity volatility, but even more to idiosyncratic bond volatility and idiosyncratic bond value-at-risk. Idiosyncratic bond volatility helps to explain spreads because it reflects not just the distribution of firm value but is also a proxy for liquidity risk. Idiosyncratic bond value-at-risk adds to this by capturing the left-skewness of the firm-value distribution. We confirm our results both for the initial 1997-2004 sample period and also out of sample for 2005-2009, which includes the sub-prime crisis. Overall, credit spreads are large because they incorporate a large risk premium related to investors' fears of extreme losses.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Banking & Finance.

    Volume (Year): 35 (2011)
    Issue (Month): 8 (August)
    Pages: 2021-2036

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    Handle: RePEc:eee:jbfina:v:35:y:2011:i:8:p:2021-2036

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    Web page: http://www.elsevier.com/locate/jbf

    Related research

    Keywords: Bond Idiosyncratic risk Downside risk Credit spread puzzle Pricing kernel Liquidity Sub-prime crisis;

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    Cited by:
    1. Jubinski, Daniel & Tomljanovich, Marc, 2013. "Do FOMC minutes matter to markets? An intraday analysis of FOMC minutes releases on individual equity volatility and returns," Review of Financial Economics, Elsevier, vol. 22(3), pages 86-97.
    2. Nejadmalayeri, Ali & Singh, Manohar, 2012. "Corporate taxes, strategic default, and the cost of debt," Journal of Banking & Finance, Elsevier, vol. 36(11), pages 2900-2916.

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