Irrational Belief And Credit Spreads Puzzle

In this paper, we extend the Merton's structured approach to incomplete market economy, in which investors may have irrational or distorted belief about the corporate's future cash flow. Our theoretical model implies irrational belief generates an additional risk. In detail, as distorted belief increases, the corporate values decreases, but the corporate value volatility and negative risk neutral skewness increase.Furthermore since risky corporate bonds are proportional to a short put on the corporate value, credit spreads widen. So irrational belief help to explain the credit spreads puzzle. Finally, we use empirical analysis to test our model results and find that the coefficient of distorted belief in the regressions for credit spreads, in control of many variables, still significant positive.