Time-Varying Asset Volatility and the Credit Spread Puzzle

54 Pages Posted: 14 Oct 2011

See all articles by Redouane Elkamhi

Redouane Elkamhi

University of Toronto - Rotman School of Management

Jan Ericsson

McGill University; Swedish Institute for Financial Research (SIFR)

Min Jiang

University of Iowa - Henry B. Tippie College of Business

Date Written: October, 13 2011

Abstract

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.

Keywords: Variance risk premia, default swaps, structural credit models

Suggested Citation

Elkamhi, Redouane and Ericsson, Jan and Jiang, Min, Time-Varying Asset Volatility and the Credit Spread Puzzle (October, 13 2011). Paris December 2011 Finance Meeting EUROFIDAI - AFFI, Available at SSRN: https://ssrn.com/abstract=1943575 or http://dx.doi.org/10.2139/ssrn.1943575

Redouane Elkamhi

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada

Jan Ericsson

McGill University ( email )

1001 Sherbrooke St. West
Montreal, Quebec H3A1G5 H3A 2M1
Canada
(514) 398-3186 (Phone)
(514) 398-3876 (Fax)

HOME PAGE: http://people.mcgill.ca/jan.ericsson/

Swedish Institute for Financial Research (SIFR)

Drottninggatan 89
SE-113 59 Stockholm, SE-113 60
Sweden

Min Jiang (Contact Author)

University of Iowa - Henry B. Tippie College of Business ( email )

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Iowa City, IA 52242-1000
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