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Can Higher-Order Risks Explain the Credit Spread Puzzle?

Author

Listed:
  • Okou, Cedric

    (University of Quebec at Montreal)

  • Maalaoui Chun, Olfa

    (KAIST)

  • Dionne, Georges

    (HEC Montreal, Canada Research Chair in Risk Management)

  • Li, Jingyuan

    (Lingnan University)

Abstract

We tweak the conventional Merton model to account for the asymmetric properties of assets returns and investors asymmetric behavior toward the upside potential of gain versus the downside risk of loss. Using an asymmetric split normal distribution, we capture empirical asymmetries in the underlying return distribution, while we conserve the attractiveness of delivering closed-form pricing formulas that collapse to the basic Merton model in the symmetric Gaussian case. The asymmetric specification outperforms the symmetric one in matching high levels of historical credit spreads. We then link the residual (non-default-model-implied) spread to two illiquidity risk factors. The first factor is extracted from several measures of idiosyncratic illiquidity variables and the second factor is a systematic factor obtained from a general index common to all studied bonds. Our model explains 70% of the BBB-AAA spread and more than 72% of BBB and AAA credit spreads relative to the on-the-run Treasury rates.

Suggested Citation

  • Okou, Cedric & Maalaoui Chun, Olfa & Dionne, Georges & Li, Jingyuan, 2016. "Can Higher-Order Risks Explain the Credit Spread Puzzle?," Working Papers 16-1, HEC Montreal, Canada Research Chair in Risk Management.
  • Handle: RePEc:ris:crcrmw:2016_001
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    References listed on IDEAS

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    More about this item

    Keywords

    Credit spread puzzle; Asymmetry; Illiquidity; Higher-order risks.;
    All these keywords.

    JEL classification:

    • D51 - Microeconomics - - General Equilibrium and Disequilibrium - - - Exchange and Production Economies
    • D80 - Microeconomics - - Information, Knowledge, and Uncertainty - - - General
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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