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Inflation Uncertainty, Asset Valuations, and the Credit Spreads Puzzle

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  • Alexander David
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    Abstract

    Investors' learning of the state of future real fundamentals from current inflation leads to macroeconomic state dependence of asset valuations and solvency ratios of firms within given rating categories. Since credit spreads are convex functions of solvency ratios, average spreads are higher than spreads at average solvency ratios. Macroeconomic shocks carry risk premiums so that expected default losses are more sensitive to changes in the price of risk than are credit spreads. By incorporating state dependence and increasing the price of risk, the econometrician obtains high credit spreads while maintaining average default losses at historical levels—the credit spreads puzzle. The Author 2007. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org., Oxford University Press.

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    Bibliographic Info

    Article provided by Society for Financial Studies in its journal The Review of Financial Studies.

    Volume (Year): 21 (2008)
    Issue (Month): 6 (November)
    Pages: 2487-2534

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    Handle: RePEc:oup:rfinst:v:21:y:2008:i:6:p:2487-2534

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    Cited by:
    1. Alexander David & Pietro Veronesi, 2009. "What Ties Return Volatilities to Price Valuations and Fundamentals?," NBER Working Papers 15563, National Bureau of Economic Research, Inc.
    2. Georges Dionne & Geneviève Gauthier & Khemais Hammami & Mathieu Maurice & Jean-Guy Simonato, 2010. "A Reduced Form Model of Default Spreads with Markov-Switching Macroeconomic Factors," Cahiers de recherche 1042, CIRPEE.
    3. Susan S Sharma & Kannan Thuraisamy, 2012. "Oil Price Uncertainty and Sovereign Risk: Evidence from Asian Economies," Financial Econometics Series 2012_02, Deakin University, Faculty of Business and Law, School of Accounting, Economics and Finance.
    4. Beber, Alessandro & Breedon, Francis & Buraschi, Andrea, 2010. "Differences in beliefs and currency risk premiums," Journal of Financial Economics, Elsevier, vol. 98(3), pages 415-438, December.
    5. Chan, Kam Fong & Marsden, Alastair, 2014. "Macro risk factors of credit default swap indices in a regime-switching framework," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 29(C), pages 285-308.
    6. Wang, Hao & Zhou, Hao & Zhou, Yi, 2013. "Credit default swap spreads and variance risk premia," Journal of Banking & Finance, Elsevier, vol. 37(10), pages 3733-3746.
    7. Tang, Dragon Yongjun & Yan, Hong, 2008. "Market conditions, default risk and credit spreads," Discussion Paper Series 2: Banking and Financial Studies 2008,08, Deutsche Bundesbank, Research Centre.
    8. Pu, Xiaoling & Zhao, Xinlei, 2012. "Correlation in credit risk changes," Journal of Banking & Finance, Elsevier, vol. 36(4), pages 1093-1106.

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