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Ambiguity, Volatility, and Credit Risk

Author

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  • Patrick Augustin
  • Yehuda Izhakian
  • Stijn Van Nieuwerburgh

Abstract

We explore the implications of ambiguity for the pricing of credit default swaps (CDSs). A model of heterogeneous investors with independent preferences for ambiguity and risk shows that, because CDS contracts are assets in zero net supply, the net credit risk exposure of the marginal investor determines the sign of the impact of ambiguity on CDS spreads. We find that ambiguity has an economically significant negative impact on CDS spreads, on average, suggesting that the marginal investor is a net buyer of credit protection. A 1-standard-deviation increase in ambiguity is estimated to decrease CDS spreads by approximately 6%.

Suggested Citation

  • Patrick Augustin & Yehuda Izhakian & Stijn Van Nieuwerburgh, 2020. "Ambiguity, Volatility, and Credit Risk," The Review of Financial Studies, Society for Financial Studies, vol. 33(4), pages 1618-1672.
    • Handle: RePEc:oup:rfinst:v:33:y:2020:i:4:p:1618-1672.
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    File URL: http://hdl.handle.net/10.1093/rfs/hhz082
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    Citations

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    Cited by:

    1. Czech, Robert, 2021. "Credit default swaps and corporate bond trading," Journal of Financial Intermediation, Elsevier, vol. 48(C).
    2. Andrea Ugolini & Juan C. Reboredo & Javier Ojea-Ferreiro, 2023. "Is climate transition risk priced into corporate credit risk? Evidence from credit default swaps," Working Papers 509, University of Milano-Bicocca, Department of Economics.
    3. Fu, Ruonan & Melenberg, Bertrand & Schweizer, Nikolaus, 2023. "Comment on “A theoretical foundation of ambiguity measurement” [J. Econ. Theory 187 (2020) 105001]," Journal of Economic Theory, Elsevier, vol. 207(C).
    4. Gao, Feng & Li, Yubin & Wang, Xinjie & Zhong, Zhaodong (Ken), 2021. "Corporate social responsibility and the term structure of CDS spreads," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 74(C).
    5. Yehuda Izhakian & David Yermack & Jaime F. Zender, 2022. "Ambiguity and the Tradeoff Theory of Capital Structure," Management Science, INFORMS, vol. 68(6), pages 4090-4111, June.
    6. Massari, Filippo & Newton, Jonathan, 2020. "When does ambiguity fade away?," Economics Letters, Elsevier, vol. 194(C).
    7. Ben-Rephael, Azi & Cookson, J. Anthony & izhakian, yehuda, 2022. "Do I Really Want to Hear The News? Public Information Arrival and Investor Beliefs," SocArXiv ud7yw, Center for Open Science.
    8. Takao Asano & Xiaojing Cai & Ryuta Sakemoto, 2023. "Time-varying ambiguity shocks and business cycles," KIER Working Papers 1094, Kyoto University, Institute of Economic Research.
    9. Chen, Qiang & Han, Yu, 2023. "Options market ambiguity and its information content," Journal of Financial Markets, Elsevier, vol. 64(C).
    10. Ben-Rephael, Azi & Cookson, J. Anthony & izhakian, yehuda, 2022. "Trading, Ambiguity and Information in the Options Market," SocArXiv ewunv, Center for Open Science.
    11. Hasan, Iftekhar & Marra, Miriam & To, Thomas Y. & Wu, Eliza & Zhang, Gaiyan, 2023. "COVID-19 Pandemic and Global Corporate CDS Spreads," Journal of Banking & Finance, Elsevier, vol. 147(C).
    12. Qiang Chen & Yu Han & Ying Huang, 2024. "Market‐wide overconfidence and stock returns," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 44(1), pages 3-26, January.

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