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The Negative Credit Risk Premium Puzzle: A Limits to Arbitrage Story

Author

Listed:
  • Chris Godfrey

    (ICMA Centre, Henley Business School, University of Reading)

  • Chris Brooks

    (ICMA Centre, Henley Business School, University of Reading)

Abstract

Prior research has documented that, counter-intuitively, high credit risk stocks earn lower not higher returns than low credit risk stocks. In this paper we provide evidence against rational expectations explanations, and show that a model incorporating limits-to-arbitrage factors is capable of explaining this apparent anomaly. We demonstrate that the negative pricing of credit stocks is driven by the underperformance of stocks which have both high credit risk and which have suffered recent relative underperformance, and that their ongoing poor performance can be explained by a mixture of four limits-to-arbitrage factors idiosyncratic risk, turnover, illiquidity and bid-ask spreads. Collectively, these impede the correction of mispricing by arbitrageurs, especially on the short leg of the trade, where commonly reported returns are unattainable.

Suggested Citation

  • Chris Godfrey & Chris Brooks, 2015. "The Negative Credit Risk Premium Puzzle: A Limits to Arbitrage Story," ICMA Centre Discussion Papers in Finance icma-dp2015-07, Henley Business School, Reading University.
  • Handle: RePEc:rdg:icmadp:icma-dp2015-07
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    File URL: http://www.icmacentre.ac.uk/images/2015/11/ICM-2015-07-Godfrey-and-Brooks.pdf
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    behavioural finance; relative distress; credit risk premium puzzle; asset pricing; limits to arbitrage;

    JEL classification:

    • C31 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Cross-Sectional Models; Spatial Models; Treatment Effect Models; Quantile Regressions; Social Interaction Models
    • C55 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Large Data Sets: Modeling and Analysis
    • D03 - Microeconomics - - General - - - Behavioral Microeconomics: Underlying Principles
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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