The pricing of unexpected credit losses
AbstractWhy are spreads on corporate bonds so wide relative to expected losses from default? The spread on Baa-rated bonds, for example, has been about four times the expected loss. We suggest that the most commonly cited explanations – taxes, liquidity and systematic diffusive risk – are inadequate. We argue instead that idiosyncratic default risk, or the risk of unexpected losses due to single- name defaults in necessarily "small" credit portfolios, accounts for the major part of spreads. Because return distributions are highly skewed, diversification would require very large portfolios. Evidence from arbitrage CDOs suggests that such diversification is not readily achievable in practice, and idiosyncratic risk is therefore unavoidable. Taking a cue from CDO subordination structures, we propose value-at-risk at the Aaa-rated confidence level as a summary measure of risk in feasible credit portfolios. We find evidence of a positive linear relationship between this risk measure and spreads on corporate bonds across rating classes.
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Bibliographic InfoPaper provided by Bank for International Settlements in its series BIS Working Papers with number 190.
Length: 46 pages
Date of creation: Nov 2005
Date of revision:
credit spread puzzle; jump-at-default risk; Sharpe ratio; collateralised debt obligation;
Find related papers by JEL classification:
- C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
- C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
- G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
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- Kim, Don H. & Loretan, Mico & Remolona, Eli M., 2010.
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