Fat Tails, Illiquidity, and Uncertainty as Explanations of The Credit Spread Puzzle

Structural models of default risk price firm’s equity and debt as contingent claims written on the firm’s underlying assets. However, the empirical literature has detected that observed credit spreads, particularly for safer firms, tend to be on average above their structural models’ predictions (the credit spread puzzle). This paper investigates possible explanations for the credit spread puzzle, using data on the credit default swaps of 40 U.S. investment-grade firms from 2005 to 2009. Firstly, the paper explores the contribution of downside risk, by calibrating the Merton model (1974) on an empirical measure of the sensitivity of credit default swaps to equity volatility, rather than directly on a proxy for asset volatility. The sensitivity measure, extracted from market data, is able to capture the fat left tail in the risk-neutral distribution of firm’s returns. Investors take into account the likelihood of extreme events and, to protect themselves against default, they are available to pay a higher CDS premium. Secondly, this work detects two additional components of CDS premia related to illiquidity in credit markets and investors’ aversion to uncertainty. The effects of default risk, tail risk, investors’ uncertainty, and illiquidity become particularly clear over the recent subprime crisis period when investors lingered in fear of crashes and being uncertain about firms’ fundamental values decided to withdraw from active participation. When market is illiquid and uncertainty greater, sellers of credit default swap charge more and CDS premia increase.