Time - varying asset volatility and the credit spread puzzle ∗

Structural credit risk models have faced difficulties in matching observed market credit spreads while simultaneously matching default rates, recoveries, leverage and risk premia a shortcoming that has become known as the credit spread puzzle. We ask whether stochastic asset volatility, as an extension to this model class, has the ability to help resolve this puzzle. We identify that although there are three ways in which uncertainty about asset risk can influence spreads (asset risk volatility itself, dependence between the levels of risk and asset value and finally volatility risk premia), in a calibration setting only the volatility risk premium channel is economically significant. We show that this feature of a stochastic asset risk model allows it to match historical spreads and equity volatility as well. We also provide estimates of the required variance risk premia. ∗Elkamhi and Jiang are with the Henry B. Tippie School of Business at the University of Iowa, Ericsson with the Desautels Faculty of Management at McGill University. Direct correspondence to Jan Ericsson: [email protected], 1001 Sherbrooke Street West, Montreal, H3A 1G5, Quebec, Canada. The usual disclaimer applies.